While we invest in many sectors and asset classes, the recent steep selloff in precious metal mining stocks inspired us to write an article focusing in on that particular sector's long-term fundamentals. The resulting piece was emailed to clients on September 16, 2008 and is excerpted below.
The Basic Premise
The global monetary system as it stands today is completely unsustainable. It is suffering from severe imbalances that have not yet come to the fore, and in the typical manner, the markets are assuming that if the problems haven't happened yet, that means they will never happen. While we don't know when it will happen, or whether it will be slow or abrupt, we feel certain (or as certain as one can be in financial markets) that these imbalances will surface at some point and that confidence in the monetary system is likely to fall precipitously in the years ahead.
To summarize the current monetary system, it is a system based entirely on paper money with the US dollar as the "reserve" currency.
The "paper money" part means that governments can and do print more money at will when it suits them to do so. The "reserve" part means that dollars tend to be used as the international store of value and medium of trade.
The result of this system is that the foreigners' willingness to stockpile US dollars has allowed us to go into astonishing levels of foreign debt. This has allowed us as a nation to consume more than we produce for many years.
The system has further fed upon itself because as we've become an ever more important consumer of foreign-made goods, mercantilist governments have purposely propped up the value of the dollar to help their export sectors. Many of our foreign trade partners lend us money, which we spend on their goods, after which they lend the money back to us, so we can buy more goods from them... and the process repeats.
Governments do it because it keeps people employed in the short term. And they've been doing it even more as they are now sitting on hundreds of billions of dollars worth of US-dollar denominated assets. So if they let the dollar drop, they will not only have to deal with politically instability resulting from export sector unemployment, but will also take huge losses on the dollars they already own.
So the game continues, with the stakes getting higher all the time. By lending back the money that we use to buy their goods, foreign governments keep accepting our IOU's -- but those IOU's only maintain their value becaue foreign governments keep accepting them. And the IOU pile just keeps growing and growing.
Something's got to give eventually. It's most likely that the transition off of this system will be slow, with foreign central banks slowing down their accrual of dollar-denominated IOUs, accepting the losses on their existing dollar stockpile, and allowing their export sectors to shrink to a more sustainable size. Alternatively, the transition could be violent, with foreign countries panicking out of their dollar holdings. Either way, this "dollar recycling" system is entirely unsustainable over the long haul and must end eventually. When the dollar recycling system goes into reverse or breaks down, the artificial props under the dollar's value will be removed and alternate stores of value such as gold will become far more sought after.
But the system needn't even break down for gold to benefit. The only way foreign governments can prop up our currency is by making theirs less valuable. So we have a situation where every nation is creating currency at a breakneck pace, with the result that every piece of paper currency becomes ever more worthless. In a world where no paper money is a good store of value, gold is an excellent alternative. I believe that the rise in the gold price in recent years reflects that this realization is slowly dawning among a few people here and there. But the existence of a few "early adopters" out there doesn't change the fact that we are a long, long way from the severity of the situation -- and the un sustainability of the dollar recycling system -- being widely understood.
Bailouts and Reflation
Because the dollar recycling system has given us a free pass to create new money, we have monetary and legislative authorities who openly support currency debasement as a policy tool when it suits their needs (which is often). In the wake of the tech stock crash in 2000-2002, the Fed printed huge volumes of new money and kept real interest rates in negative territory for a protracted period. This stoked an inflationary boom which got us out of the 2001 recession and, despite leading to the current mess, is widely considered to have been a policy success.
While the Fed has so far been a bit more circumspect on the overt money printing this time around, the government's intervention of the economy has been far more dramatic:
The Treasury has nationalized the two institutions that buy 80% of the nation's mortgages and own or guarantee $5 trillion in mortgage debt.
The Fed has kept its target rate lower in comparison to inflation than at any time in decades.
Congress has sent "stimulus checks" out to households to encourage more consumption.
The government is actively brokering deals to have the more stable financial institutions bail out their less stable brethren.
The Fed guaranteed $30 billion in debt, much of it worthless junk mortgage debt, of the now-defunct Bear Stearns.
The Fed has been lending huge amounts of money to financial institutions, accepting mortgage backed securities and other questionable assets as collateral for the loans (this hasn't been direct money printing, but it has allowed banks to pretend their assets are worth more than they actually are, which has a similar effect).
As of yesterday the Fed has ramped up their lending to financial institutions and are now accepting equities as collateral (this directly props up share prices because now institutions in need of money can borrow taxpayer funds against their shares instead of selling them on the market).
That's off the top of my head... the list goes on.
All this nationalizing, lending, stimulating, and guaranteeing involves money that we -- as a debtor nation -- do not have. The money is therefore either being printed into existence or borrowed. To the extent that it is borrowed, that just means that it will be printed in the future instead of being printed right now (as described in the next section). The end result more money printing, which decreases the value of each unit of money in existence.
Many of the bailout attempts thus far have been largely aimed at preventing a credit contraction. But as the economic woes mount, the government will likely begin to also start focusing on stimulating the general economy via continuing to keep interest rates at artificially low levels, more stimulus checks, and more monetary growth. The Fed funds rate is extremely low compared to the CPI inflation rate and they will likely lower rates before they raise them. And just yesterday morning they dumped more money into the banking system than they have since the 9/11 attacks. In short, I believe the really inflationary policy is still to come.
It's important to understand that while price increases may slow in the short term due to the economic slowdown and financial panic, that very dynamic itself makes it much more likely that the reflation attempts will be ever more dramatic. In other words, the bigger the apparent problems in the short term, and the more inflation moderates in the short term, the more inflation pressures are likely to be put in the pipeline as the government tries to print, borrow, and stimulate their way out of this mess as they always have over the past two decades.
Because foreigners' buying of US debt is the primary mechanism for dollar recycling, at this point we owe a tremendous amount to foreigners. For example, foreigners own one half of all the US Treasuries (government debt) in the world.
Right now, we are still able to accrue debt faster than we are paying it off, because foreign nations are still recycling the dollars they receive. But the time will come when we have to start paying that debt.
There are two ways to pay off debt that is owed to foreigners and denominated in dollars:
Collectively as a nation, stop spending so much money, and instead lower our standards of living so much that we have enough extra money to both pay back foreign debt and start to save money for ourselves again.
Given the short sightedness of politicians and their unwillingness to address the debt problem, option #1 is not feasible. The money we owe to foreigners implies a high probability for future inflation simply because it would be too politically painful to pay back the money out of our real earnings when we have the option to just print the money into existence. This may be a longer-term consideration, but it nonetheless has highly inflationary ramifications.
Implications for Gold
Gold's fundamental underpinning is confidence, or more specifically lack of confidence, in the monetary system. The more confident people are in central banks and the monetary system they run, the less of a premium they are willing to pay for an alternate store of value like gold -- and vice versa.
So at the most fundamental level, the question to ask is: in the future, are people likely to become more confident or less confident in the monetary system? Given the entirely unsustainable nature of the dollar recycling system, our mountain of foreign dollar-denominated debt, the astonishing complacency at the serial bailouts and inflationary monetary policy inflicted by the government, and the likelihood of even more bailouts and monetary growth, we believe that people have far, far too much confidence in the monetary system at this point.
When the unsustainable imbalances of the current setup finally come to the surface, we believe we are in store for a serious drop in confidence in the global monetary system and its standard-bearer, the US dollar. At that point, we believe that gold will have attained a far higher premium than it has now.
Gold is difficult to value by traditional means because it doesn't have a price-to-earnings ratio or any of the typical metrics by which one can value stocks or other assets. But we can get a ballpark idea of how expensive it is by looking at how much it costs compared to other investments.
For example, stock prices tend to rise as confidence in the monetary system is rising and fall when confidence is falling, whereas gold does the opposite. So looking at the ratio of the prices of stocks to the price of gold can tell you how much monetary confidence is being "priced in" at any given time.
The following chart shows about 70 years of the Dow to Gold ratio (which divides the price of the Dow Jones Industrial Average to the gold price and thus measures how expensive stocks are compared to gold). When the line is higher, that means stocks are more expensive in comparison to gold, and a lower line means gold is more expensive:
As you can see, the system is still pricing in a high degree of confidence in the monetary system. We are off the all-time confidence highs that occurred in 2000, when people thought Greenspan was a god and stocks could only go up. But the ratio is still fairly high from a historical perspective, and it's extremely high given the structural risks to the current monetary system described in the prior section.
In short, this chart indicates that people are still far more confident in the monetary system than they ought to be, and that gold is poised to outperform stocks for quite some time.
Another way to look at gold's valuation would be to compare the price of gold with the supply of US dollars. The idea here is that dollar itself has no value except as a claim on real wealth. If you increase the supply of dollars without increasing real wealth, each dollar then represents less wealth than it did before. All things equal, then, an increase in the supply of dollars represents a reduction in the purchasing power of the dollar.
Comparing the rate of change in money supply growth (purchasing power loss) to the rate of change of the gold price can provide another indication of monetary confidence. The following chart does just that by dividing the price of gold by the number of US dollars in existence as measured by the monetary aggregate M2:
The chart shows that the gold price rises faster than the growth in the money supply when monetary confidence is falling and vice-versa. Right now, monetary confidence is falling. But as with the last chart, it hasn't fallen much considering the uniquely dollar-bearish situation and the fact that we came out of a 20-year period of rising and ever less reasonable monetary complacency.
Given that we would expect this ratio to rise, and given that we expect a lot of money supply growth in the year ahead, this chart also bodes well for gold prices.
Finally, consider the following chart of Consumer Price Index inflation-adjusted interest rates in comparison to the above two charts:
It's no coincidence that the gold price has risen (in nominal terms as well as compared to both stock prices and the money supply) during periods when real rates were negative and that it's fallen when real rates are positive. As discussed in a recent website article, negative real rates tend to reduce confidence in money as a store of value and to cause inflation. It makes perfect sense that gold has tended to rise in such situations.
Real rates are more negative right now than at any time in almost 30 years. CPI inflation may well back off for a while, but it won't do so enough to turn rates positive. Meanwhile, the Fed is more likely to cut rates than to raise them. So negative real rates can be expected to continue chipping away at monetary confidence for some time to come.
Once you establish that gold is either at or under its fair value, it is fairly straightforward to compare the prices of the mining stocks to the price of gold.
The best valuation metric for gold miners is to look at the value of the gold they have in the ground. There are other factors, of course, such as political risk and extraction costs. We look at these things too, but the simplest way to view the mining sector as a whole is to compare the price of gold (as a proxy for the value of the gold miners have in the ground) to the price of a gold stock index.
By that metric, as seen in the following chart, the XAU index of gold stocks is cheaper in comparison to gold than it has been at any time over the last couple of decades (today's value is 1.54 -- it doesn't show up on the chart but it is lower than any of the prior lows on the chart):
In the year 2000, the gold price was lower than the typical cost of production. Gold miners couldn't make any money. They were at risk of going out of business and were priced as such. So as of right now, even though many gold miners are generating great profits and are sitting on very valuable stores of gold, the gold sector is priced even lower than when it was on the brink of mass bankruptcy. The market appears to be severely undervaluing gold stocks.
The gold mining sector is by its nature very volatile. The HUI index of gold mining stocks dropped by over 30% in 2002, again in 2004, and yet again in 2006-- and it dropped by over 60% between 1999 and 2000. In each case, the HUI eventually went on to make new highs. (And that's the whole index by the way -- the smaller individual stocks within the index were far more volatile than that).
Even by mining sector standards, however, the current correction has been very rough. As I've mentioned, we believe that there has been a mass liquidation by hedge funds and other leveraged speculators who had all piled into the sector during the dollar selloff earlier this year. The fact that these speculators are being shaken out has little to do with the fundamentals, however, as the above charts hopefully demonstrate.
The rally in the dollar and the selloff in gold and gold stocks over recent months has led many people to believe that inflation and purchasing power loss are no longer a threat. But we've seen many times before that the market often doesn't acknowledge a problem until long after those problems become apparent. Eventually, reality asserts itself and the market acknowledges the problem.
Well, there is a giant problem with the dollar as a store of value. Given the unstable nature of our monetary system and the misplaced confidence in paper money as a store of value, gold is still quite reasonably priced and should be expected to rise substantially in the years ahead. And given that gold is reasonably priced, gold stocks are dirt cheap.
Short-term market movements have never been our stock-in-trade. We try to identify opportunities that present good long term investment value given the underlying trends and inevitabilities. Market gyrations and hedge fund liquidations notwithstanding, we believe that from a long-term fundamental standpoint, gold and gold stocks continue to be a great long-term investment.
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