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Gold: The Big Lie

Perspective Cartoon - 540 Mill Spent in 80 Minutes

Stock markets, oil, and government bonds rallied when the Greek bailout averted a Eurozone catastrophe and nascent signs that the US economy is improving gave investors encouragement. Gold and commodities collapse. The glass, this time is half full. The markets even celebrated the massive purchases of debt by every central bank from the Fed to the European Central Bank to the IMF as part of the largest sovereign debt restructuring in history. However to us, this appears to be just another false dawn.

As a result, the Fed's balance sheet has tripled, bloated with billions of newly minted Treasuries and mortgage-backed securities. With so much stimulus, it is a surprise that the economic recovery is so tepid and other than maybe the stock market, quantitative easing has achieved so little economic returns. Similarly the European Central Bank's balance sheet too has exploded over $4 trillion and yet there are even plans for another increase in the Eurozone's so called "firewall". They are hardly alone. Japan and the Bank of England are also printing money.

But there are consequences. The Fed's money creating power is virtually unlimited. The Federal Reserve increased its balance sheet by $2 trillion in just two rounds of Quantitative Easing, buying Wall Street's toxic paper and their own Treasury securities with newly created dollars. The consequence of this massive creation of liquidity though is a weaker dollar which should boost exports but to date, the US trade gap has widened, not narrowed. And already the weaker dollar has raised commodity prices like oil. America and Europe are simply borrowing economic growth from their future, sowing the seeds for the next crisis. Quantitative Easing is no free lunch. The inconvenient truth is that the worst is yet to come. Inflation is next.

Debt Woes

The fundamental challenges facing the Eurozone are well documented as its members creep towards a fiscal union to avoid another crisis. The reality is that the problem of the past and the future is too much debt which has not yet been addressed despite numerous summits and bailouts. The liquidity injections only bought time and eventually conventional monetary policy reaches its limits too. Already the borrowing costs are climbing again in Italy and Spain.

At the same time, America should be tackling their problems but the crony capitalism cost of the US presidential election keeps on mounting with special interest groups, lobbyists, and Wall Street pandering for support. The "Occupy Movement" of course is frustrated because not only is democracy being bought and sold, but daily events in Greece and Italy suggests that unelected technocrats are now in charge. That most of them are refugees from Goldman Sachs has not gone unnoticed. The irony today is that taxpayers are being asked to pay the price of governments' financial prolificacy leaving a legacy of debt on their citizens. With the latest bailout in Greece, it appears the technocrats are now thrust in the role of bailing out the same banks from whence many came.

In solving Greece's problems with more debt and subsidizing the financial sector with ultra cheap money, further imbalances appear. And in lending money to the banks to buy government bonds, central banks are really purchasing monetary liabilities and these liabilities have become a major part of their balance sheets. Central bankers, the new grand masters of money were supposed to be stewards of our money, not creators. Shrinking those liabilities will be the big challenge because since 2007 the Fed's balance sheet has grown by 222 percent while the Bank of England's has grown 82 percent.

A Recipe for Inflation?

We believe with central banks buying most of that debt themselves, the printed money will eventually find its way into the economy causing inflation. Although there is currently no evidence of that, there is an extraordinary link between the printing of money and inflation. In fact, there are historic parallels between the present economic crisis and money printing periods of the hyperinflation periods in Germany in the 1920s, French fiat inflation in the late 1890s and Chinese hyperinflation between 1935 and 1947. We studied 25 hyperinflation episodes in the past and the history of hyperinflation is really a history of monetization of debt. Those governments replaced a hard currency system with a paper system, dependant of course on the integrity of governments for its value. A clear lesson with these periods was that they all have in common, the lack of a money standard, currency devaluations, deficit spending and central bank collusion which is all too common today.

Inflation, Milton Friedman once said is a "monetary phenomena". Government bonds were savaged by inflation in the 1960s and 1970s. Already the swelling in monetary supply has translated into a spike in the monetary base and the bond market has been going down not up. The big challenge is to reduce deficits through the inevitable tightening, shrinking the Fed's balance sheet and raise rates - but Bernanke himself has postponed that decision until 2014. The US doesn't have the luxury of time. The markets today have become addicted to cheap money and like any drug, there are side effects. Gold is good thing to have.

The Muppet Show

The more things change, the more they remain the same. Today's investment bankers and hand maidens of the central banks are still the most hated and one recently lost his knighthood. Trust is gone. Reviled and mistrusted, financial institutions are simply losing their relevance. An investment banker's much publicized resignation from Goldman Sach's went viral - amid accusations that Goldman's clients or "Muppets" came last. MF Global's missing billions is now over $1.6 billion and the fury against the one percent escalated, whipped up in a politics of blame by US politicians who are fighting for their jobs this fall. The economic debate between the move to austerity and those who are pushing for growth has blurred amid crony capitalism, class warfare and the politics of blame.

Beneath all this, there are the banks who created complex derivatives like credit default swaps (cds) to earn big fees as well as protect themselves with off balance sheet liabilities, Banks have become too dependent on cheap funding using the largesse not to make new loans but to restructure their balance sheets and of course stock up on the debt of their own governments in a "quid pro quo" move. However the complexity of those products led to the recent restructuring of Greek government debt which was a defacto default, forcing the International Swaps and Association (ISDA) which is made up of the same members who underwrote the swaps, to declare a $3 billion credit event or default. But, how much was really paid out and did holders receive their so-called insurance? At the heart of this legal lie is debt really sustainable? Instead investment bankers in trying to fill the void with financial engineering, have hoisted themselves on their own petard.

Deficit Disorder Bar Graph

Washington remains mired in gridlock. America will go through another year without a budget following the repudiation of Mr. Obama's new federal budget which was defeated by both Houses after calling for a fourth fiscal year of deficits greater than $1 trillion. Mr. Obama has over-regulated, expanded government spending and his Obamacare program threatens to be dismantled by the Supreme Court. America has completed four years of public spending at more than 24 percent of their GDP, the highest spending years since 1946 with little to show for it.

Living beyond their means will make it even harder to service their growing debt. Revenues despite much huffing and puffing are pegged at an historic low of 15 percent of GDP and the resulting deficits are unsustainable because both political parties and Mr. Obama are reluctant to hurt their election chances with their funding benefactors. Mr. Obama is ready to jump into the same financial hole left by Greece. Entitlements? Entitlement spending is on track to take up 100 percent of government revenues by 2030. Public debt stands at 90 percent of GDP and rising. Yet, they are too important to be talked about in the upcoming election and it appears that the debt ceiling debacle will renew itself before November. Remarkably, the markets remain oblivious.

Debt Time Bomb

Chart: How the Fed Funds Deficit Spending

The US national debt is a whopping $15 trillion and rising daily. The Fed has financed Mr. Obama's spending by borrowing through the expansion of its balance sheet through massive purchases of Treasury debt. And by flooding the system with dollars, sovereign debt interest rates reached new lows at the expense of the purchasing power of the US dollar. However it appears that the Federal Reserve's promise to keep rates near zero until 2014 really is more rhetoric given the reality that some $5 trillion of US debt or one third of US indebtedness comes due within the next three years. The conventional wisdom is that there is infinite demand for US Treasury debt and dollars. Wrong. This year the Fed had to purchase almost three quarters of US Treasury issuances because foreigners have lost interest. China, one of the big holders of US dollars, reduced its purchases this year and Japan the second largest holder actually repatriated funds. At a time of record US sovereign debt issuances, not even the Fed will be able to refinance $5 trillion. Europe's problems surfaced because when their debt matured, a liquidity crisis led to sky-high prices and a collapse in bond prices. And since the debt was held by banks, it quickly morphed into a banking crisis.

The underlying problem is that China's $3.2 trillion foreign exchange reserves are the largest in the world and China's holdings of US Treasuries, are second only to the Federal Reserve. However in the past 12 months, China has only purchased about 15 percent of Treasuries and actually reduced their dollar denominated assets, no doubt due to concerns about the US obligations after the debt ceiling debacle and gridlock in Washington. At one time, China held 74 percent of its foreign exchange reserves in dollars. Today there are alternatives such as European debt, gold, oil and even higher rated sovereigns like Australia and Canada. Beijing has already started on the road to internationalize the renminbi with full convertibility and ultimately reserve currency status, replacing in time the American dollar"s exorbitant privilege. With the need for dollars less today, who will refinance America's $5 trillion obligations which come due within three years? Even America's private sector such as Pimco, the largest fund in the world has avoided purchasing US debt.

So far stock and bond markets have ignored the risk to the economy. We only have to look overseas for the consequence of borrowing cheaply, overspending wildly, leverage and manipulating interest rates to see the end result. We believe that a sovereign debt crisis will explode again, this time when Uncle Sam, hat in hand, has to refinance some of that $5 trillion of debt. The other time bomb is when America bumps into the debt ceiling again due to the expiration of the Bush tax cuts. And there are the $1.2 trillion of automatic spending cuts early next year that the new President must tackle. A debt implosion is in the making and no one cares to defuse this time bomb.

Gold - He Who Owns the Gold Makes the Rules

By default then, gold will have an important role. Although Warren Buffett doesn't agree, calling gold "forever unproductive" because it "never produces anything". True, gold was never a machine that produces widgets. It is a finite resource, very scarce and can't be produced out of thin air. Gold is even used as collateral. India's demand is up, with some 500 tonnes of gold used as collateral. So many keep gold that the government raised import taxes and capped its usage as collateral against loans. The United Arab Emirates (UAE) allows customers to borrow against the value of their gold. Korea actually pledged their 100 tonnes of gold to get loans. Gold then has a daily usage.

Gold is also a store of value. Until 2010, central banks were the single largest source of gold, selling more than 400 tonnes every year. In addition some loaned gold in ill founded hedging schemes. However, that changed with the sovereign debt problems and the weaker greenback. Today, central banks are net buyers of gold, purchasing the most gold since 1964 after twenty years of reducing their gold reserves. Central banks bought almost 100 tonnes in 2010 and 500 tonnes last year as emerging countries rebuilt their stockpiles. Now there seems to be a move towards repatriation of those reserves held in largely western vaults.

Gold is limited and it is precisely for that reason it has been used as money for several thousands of years. Gold's move to near record highs is due to its hedge characteristics against a possible breakdown of the international financial system, a growing possibility these days. Further, we believe that a sharp jump in inflation is inevitable as a consequence of the central banks' collective monetary easing policies and the dollar's days as a reserve currency are limited. Mr. Buffett might consider gold "unproductive", but there sure are many productive uses.

Gold Stocks Here Been Lousy Investments

While gold prices are near historic highs, gold stocks in general have lagged largely because many mines have shown no growth or those that do show growth, that growth was accomplished through acquisitions which caused massive dilution. Many deals involved companies acquiring other companies for shares, creating too much paper, diluting existing shareholders which had to be absorbed by the market.

In 1992, when the European Union was founded and Whitney Houston starred in The Bodyguard, the TSX gold index was at 382.92 and gold was $392 an ounce. Today the gold index is at 316.45 or 17 percent lower while gold over the twenty year period is up over 327 percent. And some stocks did worse, with "disasters du jour" like Agnico's closure of Goldex, Randgold's Malian upheaval or Crystallex's loss of Las Cristinas. Country risk has also hurt the industry. Australia imposed a 30 percent mining tax and Indonesia escalated resource nationalization. Then there are the self-inflicted woes. A good example was Kinross which issued 40 percent of its shares to acquire Red Back Mining, in a deal that saw Kinross overpay resulting in almost a $3 billion goodwill writedown. Another big part of the gold miners' underperformance is that growth was due more to having expanded existing deposits because higher gold prices made lower grade deposits economic rather than new discoveries. Many ounces today are thus high cost ounces with limited lives. The gold mining industry simply has not grown reserves.

We believe to create value for shareholders, miners need to discover new deposits to replace declining reserves. Today miners' margins have more than doubled despite cost increases and many of the gold producers are awash in cash. Bigger mines have spent more money on mega developments, rather than grassroots exploration, abdicating that activity to the juniors. Miners should explore, explore and explore to discover and develop deposits - the lifeblood of the industry.

Another reason for the lagging performance is the competition from Exchange Traded Funds (ETFs) which have attracted more than $130 billion of investment because buying gold is easier and they trade more like shares. ETFs have become more popular, but are they better? Most use derivatives, possess counterparty risk and not all ETFs are alike. Caveat emptor.

Show Them the Money

To close the gap then, we believe that the gold industry should pay out higher dividends and make a higher prioritization of yield, raise yields and share the higher gold price with their shareholders. While there have been dividend increases, some like Newmont and Eldorado have linked their dividend increases to the price of gold. We think that is a good idea. To date, gold companies have been stingy with their payouts. Barrick for example pays less than 13.5 percent of its earnings in dividends and Barrick's yield is a paltry 1.40 percent. Goldcorp pays out 23.5 percent of its earnings in dividends yet its yield is a modest 1.2 percent. Kinross pays out 13.4 percent of its earnings in dividends, but the yield too is only 1.7 percent. Fallen angel Agnico-Eagle at least paid out 30 percent of its earnings in dividends and yields 2.4 percent. We believe the industry should pay out more like Agnico and boost their dividends to 30 percent which would be comparable to giant BHP which is not ashamed to share its largesse with its shareholders. We do believe that by returning capital to shareholders and increase dividends beyond the 2 percent level, the industry could differentiate itself from ETFs proving to be a catalyst to attract new investors. The gold industry should simply "show investors the money". The industry could even pay those dividends in kind or bullion which would be another catalyst to close the gap.

In Situ Reserves Are the Cheapest In the World

Today, gold miners' reserves are the cheapest ounces in the world. The gold mining industry is the only large source of new gold supply, other than the central banks who are buying gold, not selling. The top dozen producers hold almost 23,000 tonnes of in situ reserves in the ground, equivalent to almost 80 percent of central bank reserves. Gold stock valuations are too cheap. If the industry does not dig itself out this hole, we believe alternative pools of capital may well privatize some of the big players because the gold industry's in situ reserves are trading at less than $400 an ounce which is an overly large discount from the current $1650 an ounce price. No doubt gold companies do not reflect the value of their ore reserves because there's still the cost of extraction and mining risks. However, the scarcity of gold and limited supplies together with higher prices favours long term demand growth.

Rather than spend billions bringing on high cost ounces, the industry and investors would be better served by buying those ounces on Bay Street. Public mining companies seem more interested in protecting their executive suites than showing leadership. Needed of course is a consolidation of the industry. Needed is growth in ounces. We believe other players like private equity or sovereign funds will prove to be the catalyst and show the mining industry how to capitalize on cheap prices. Private equity can play a different game. Today public gold companies cannot and would not hedge their production particularly after the debacle of Barrick and others who have lost billions. However that was then and this is now. We believe that the gold industry has abundant cash flow and their balance sheets are not only pristine but could easily be leveraged. Moreover private equity could focus on those in situ reserves and hedge output sufficient to enhance reserves without worrying about outside shareholders. Free from the quarter to quarter earnings, private equity players could leverage balance sheets and utilize the cash flow from hedging to make a fortune.

Meantime, the flat markets have made this a difficult climate for the juniors to raise money. Bigger companies are spending their cash flows on mega-projects and not on exploration. Consequently supplies of gold will be limited. However, we believe the exploration stocks have 10 bagger appeal.

As such, the next big acquisition by one of these funds will spark another gold rush into gold stocks as investors would stampede into gold stocks guessing which would likely be the next target. Sadly it will take private equity to show the Street that gold stocks are the next big thing. Stocks would then close the gap and make gold stocks expensive again. Our point, is that most investors do not have to wait for private equity to show them how undervalued gold stocks are. Investors' impatience is not a virtue here.


Agnico-Eagles Mines Ltd.

We have a strong buy on Agnico because we believe their problems are behind them. Agnico lost $3 billion of market cap over the closure of Goldex which produced 200,000 ounces last year. We expect Agnico to produce 950,000 ounces this year from flagship La Ronde in northwestern Quebec, nearby Lapa a small high grade mine, the big open pit Meadowbank in Nunavut, Kittila in northern Finland and Pinos Altos in Mexico. The Company has pared back street expectations as well as changed management in line with multi-mine responsibilities. Agnico will generate excess cash flow even without Goldex which provided some $200 million of cash flow. Goldex may yet be reopened, pending a new plan and that possibility is not priced in the stock. Agnico has one of the best underground miners and the company is trading at a 30 percent discount to its peers, rather than the 30 percent premium of the past. Buy.

Centerra Gold Inc.

Centerra increased its profits in the quarter with revenues over $1 billion on production of 650,000 ounces. Centerra is the largest gold miner in central Asia with gold mining projects in Mongolia and Kyrgyzstan. Centerra has a solid balance sheet but like others lacks growth. In fact, the company slashed its guidance by about a third due to chronic pit problems and guidance is for another flat year. Centerra's balance sheet is strong but like others are looking for acquisition but have not yet pulled the trigger. It seems there are more buyers than sellers. Centerra's valuation remains cheap.

Continental Gold Ltd.

Continental is an advanced exploration company with 10 drills turning at the 100 percent owned Buritica gold/silver/zinc project in Columbia. Continental is drilling 60,000 metres focusing on two high grade vein systems and has added to the current 43-101 resource. Continental has begun a preliminary Economic Assessment (PEA) after 100,000 m of drilling was completed to date. Mining and environmental licenses are in place. Both Yaragua and Veta Sur systems are open laterally and vertically. Production could begin in 2015 but we expect a takeout before then.

Eldorado Gold Corp.

Eldorado completed its takeover of European Goldfields giving it 29.1 million ounces of reserves. Eldorado reported earnings of $0.19 in the last quarter. Eldorado now operates mines in China, Turkey, Brazil, Greece and Romania with plans to produce 1.5 million ounce by 2015, up from 800,000 ounces this year. With a cash balance of almost $500 million, Eldorado should benefit this year from expanded production from Efemcukuru, the Kisladag expansion, and output from Eastern Dragon in China. Buy.

Goldcorp Ltd.

Goldcorp has grown through a series of acquisitions and recently commented that they would still consider early stage development acquisitions. Last year Goldcorp spent $3.6 billion to acquire Argentine-based Andean Resources' 3 million plus ounces. However, Goldcorp has yet to bring earlier acquisitions like Eleanore or Cochenor deposits into production. And that is the problem with development projects that today require billions and a long lead time before commercial production. Each ounce of new production keeps costing more. We prefer Eldorado here.

Guyana Goldfields Inc.

Guyana Goldfields' balloon burst with the release of its feasibility study on the Aurora project in Guyana. Reserves were much less and the project's value was ratcheted down removing any hopes of a takeover. Nonetheless, Aurora should produce about 250,000 ounces at a cash cost of $600 an ounce, but we believe the capital cost will scare away investors. We prefer Continental Gold here.


IAMGOLD reported a drop in production and revenues due to its sale of output to partner Anglo. This year production from IAMGOLD's Westwood mine will boost production and the Company will produce only one million ounces from five mines. However, the Company's balance sheet is solid with over $1 billion of cash and no debt. Yet IAMGOLD has shown little growth and will produce between 840,000 ounces and 901,000 ounces this year at a cost of $615 an ounce. And like others, they are kicking tires of other miners. With a flat outlook, there are better growth opportunities elsewhere, unless of course the Company decided to share its wealth through higher dividends.

Newmont Mining Corp.

Newmont has almost 100 million ounces of reserves, but the miner is mired in a holding pattern. Newmont reported a fourth quarter loss because of a $1.6 billion writedown of its Hope Bay project in Nunavut. Operating earnings were also less than guidance reflecting increasing costs. Newmont is harvesting its assets and its mines in Indonesia are encountering local problems. Newmont has not replaced production for the third year in a row and the lack of growth has hurt performance. The world's second largest gold producer is expected to produce 5.2 million ounces this year, the same it did the year earlier, while capex will amount to a whopping $3.3 billion - there is something wrong with this picture. Newmont instead should pay out more if its largesse in dividends.

Maison Placements Canada Inc. Mining companies Table
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Analyst Disclosure
Company Name Trading Symbol *Exchange Disclosure code
Aurizon Mines Ltd ARZ T 1
Barrick GoldCorp ABX T 1
Centerra Gold Ltd CG T 1
Centamin PLC CEE T 1
Continental Gold CNL V 1
Eldorado Gold Corp ELD T 1
Disclosure Key: 1=The Analyst, Associate or member of their household owns the securities of the subject issuer. 2=Maison Placements Canada Inc. and/or affiliated companies beneficially own more than 1% of any class of common equity of the issuers. 3=<Employee name> who is an officer or director of Maison Placements Canada Inc. or it's affiliated companies serves as a director or advisory Board Member of the issuer. 4=In the previous 12 months a Maison Analyst received compensation from the subject company. 5=Maison Placements Canada Inc. has managed co-managed or participated in an offering of securities by the issuer in the past 12 months. 6=Maison Placements Canada Inc. has received compensation for investment banking and related services from the issuer in the past 12 months. 7=Maison is making a market in an equity or equity related security of the subject issuer. 8=The analyst has recently paid a visit to review the material operations of the issuer. 9=The analyst has received payment or reimbursement from the issuer regarding a recent visit. T-Toronto; V-TSX Venture; NQ-NASDAQ; NY-New York Stock Exchange


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