Sunday, August 28, 2011

Are precious metals currently bubble assets?

Gold and silver are asset classes which have been in decade-long secular bull markets.  Currently, gold is approaching $1800 an ounce, approximately 6% below it's all-time high, while silver is approximately $42 an ounce, 20% below it's all-time high.  Here are my opinions on where they are headed.

Mining shares have underperformed the metals themselves for 3 years, but I expect that to change soon--it may already be happening.  In fact, I think the shares may start to slingshot up past gold and silver prices.  A few reasons:

1) operational leverage.  For example, when the cost of digging up gold for a miner is $500, and the price of gold is $900, its profit is $400/oz.  When the price of gold is $1800, holders of physical gold double their returns, as the price has doubled from $900 to $1800.

However, a mining company's profit soars from $400/oz. to $1300/oz. ($1800 - $500).  That's operational leverage.  Of course, when gold declines, the shares of the mining company would theoretically have a steeper decline.  Leverage works both ways.

2) The above calculation assumes input costs are similar (energy prices have actually decreased recently, labor costs are fairly constant in a soft job market, and water costs have stabilized), and therefore profits for the mining company should more than triple, which theoretically should indicate the share price of the company should also triple.  Therefore, as oil prices decline, more top line revenue (from a higher gold price) should flow directly to the bottom line, as input costs decline.  More revenue and reduced input costs are a nice combination for company profits, which should reflect in higher share prices.

3) Smart hedge funds have been playing the long side of gold and silver (as opposed to the bullion banks who are permanently short selling gold and silver).  The hedge funds have also hedged their long positions in the precious metals by shorting the mining companies.  That's why mining shares have underperformed relative to the metals.  But as with any suppression scheme, the gravy training never lasts forever (e.g. carry trade of foreign currencies like the yen, Swiss franc, Aussie dollars), so the really smart ones exit the trade before it reverses.

Also, as equities overall collapse, and the miners have recently shown resilience by maintaining and even rising against the overall market decline, other institutional investors will soon take notice and play the long side of the mining companies.  Institutional investors are always comparing their performance relative to their peers, quarter by quarter.  Many will notice the few who have outperformed due to their high allocation to precious metals.  They in turn will initiate or add their exposure to the precious metals sector.

This alone will cause mining shares to rise.  The rise will be even more explosive as quarterly earnings reports come in higher than consensus estimates.  In other words, the mining sector will surprise on the upside, which should drive even more institutional and retail investors to shift into the lightly-covered mining equities.  After all, every major bank follows the financials, technology, industrial, consumer, transport, energy sectors, etc., but very few are overweight precious metals coverage.  Gold has had a sustained, but orderly decade-long rally, but the banks still treat that sector as if it just experienced its worst performance, when it tanked between 1980 and 2001.  The financial pundits and mainstream media still treat gold like the black plague, since they all know gold is in a "bubble".

That is slowly changing, as hedge funds and banks in London are beefing up their precious metals analyst teams.  Unless precious metals completely collapse from these levels, initiating or adding to current mining exposure could be a good call heading into the fall and winter--historically a seasonally strong period for the precious metals sector.  The smart money is already in, the BIG money comes next.  The dumb money comes last.

Ask yourself this.  Where were all the bubble callers for Nasdaq stocks in 1999, or in real estate in 2005?  They were few to be found, as the consensus believed high-tech stocks could never plunge, or that US real estate could never decline.  To suggest otherwise made you unpopular and the target for ridicule.  There was a manic rush into internet stocks, and bidding wars on secondary homes in sunshine states.  THAT is a sign of a bubble--a frenzied mania of too many buyers. 

By contrast, the rise in gold and silver has been somewhat orderly, with light media coverage--despite gold climbing in price each and every year since 2001, setting new all-time highs along the way.  Imagine if the Dow Jones achieved that with regularity--there would be headlines splashed across every major media outlet.  The anti-gold media aim to maintain the banking status quo, with sponsorship from the government and central banking cartel.

Gold has not reached its mania stage--yet.  The fact that every analyst on CNBC, Bloomberg or the average Joe on the street thinks gold is in a bubble tells me it's nowhere near a top.  In other words, the "experts" and sheep will be wrong again.  They're just angry they missed this rally for the last 10 years, and are talking their book.

I've been pounding the table for almost 3 years about buying gold and silver, and frankly, I've been on the right side of the trade.  The Ivy League, Nobel Laureate Keynesian economists have been completely wrong.  I started my coin collection as a kid in the 1970's.  I bought gold jewelry as a tourist in Asia in 1998 and 2000--that's just the thing to do when visiting Asia--buying 24 K pure gold.  I could be labeled a gold bug, but that's not entirely accurate.  Between 1980 and 1999, gold was the worst-performing asset class.  Stocks, real estate, and even bonds were the assets to own.  But since 2000, precious metals have far outperformed, on a nominal basis, as well as inflation-adjusted.  Asset classes are cyclical in nature--there's a time to buy them, and there's a time to sell them.  I don't fall in love with any particular asset class.  But when there is financial distress, and when market participants distrust paper currencies, gold and silver will have their place as safe havens and alternative currencies.

Bubbles burst when everybody and his stockbroker brother-in-law owns a certain asset--everybody is "all in", so there are no more bullish buyers left.  This never ends well, as the bubble asset has become extremely "overbought"--there are no buyers left and only potential sellers.  In other words, you'll know a bubble is about to crash when your shoeshine boy gives you stock advice, or the bartender gives advice on internet stocks (true story, it happened to me in a bar in Portland in 1999), or all your friends tell you how to flip desert condos.  Those are signs you need to exit before everybody else does.

But when everybody says we're in a bubble, we are not in a bubble.  This rally in gold still has legs--lots of it.  You want evidence?

I had read last year that only 3% of Americans own gold.  Which means it's an under-appreciated asset--at least among Americans (it is not under-appreciated among Asians, middle eastern oil sheiks, the drug cartel, or Swiss bankers.  They are all accumulating).

But since we live in America, and due to my incessant curiosity, I decided to take my own ad hoc survey, which is continuing.  I have asked friends, family, colleagues, total strangers at airports, restaurants, hotels, etc.  Of the 217 people (and counting) I have asked, exactly 9 Americans own gold.  Most give me a blank stare, and have no idea why I would ask them that, much less what form the gold comes in, how or where to buy it, etc. (like many of you who have asked me).  Many can't even begin to ask me cogent questions, like "should I buy mining shares, bars, coins, where do I store it," etc.  When prompted, the average person thinks I'm odd, or at least off-center for even asking them about something that has no relevance in their lives.  As usual, and they will find out the hard way; their action or inaction may end up having THE most relevance in their lives.

Having said that, it's the older crowd that is the most clueless, as we've been brainwashed for so long that gold is a barbaric relic, and that the only way to build wealth and prosperity is through accumulating USDollars.  Fair enough, it's worked very well for many, but then one has to explain why the USDollar has lost 90% of its value in the last 40 years.  Much of that wealth is and will be proven to be illusory when real rates of inflation are factored in (as opposed to fictitious CPI data).

It's been the younger generation that is finally opening up to the concept that the USDollar is being destroyed, and that to maintain purchasing power, one needs to hold tangible assets.  Problem is, most young people have no savings to speak of, so even if they are open to buying gold and silver as protection against devaluation, most don't own any, either.  That's why I don't ask if they think gold and silver are good hedges against currency devaluation.  I specifically ask people if they OWN any.  That usually thins the herd out considerably.

Conclusion?  Gold and silver's advances still have a long way to go.  When there is a mad dash by the masses lining up around the block of the local coin dealer, then I would rethink my investment thesis.  And those in line will be looking to BUY gold and silver, not selling it.  In a mania, buyers usually buy out of fear or greed.  With gold, buyers will be driven by BOTH fear and greed.  That's why it will be the mother of all manias, in my opinion.

Unfortunately for the average person, that's when the bubble will burst, because by then, prices will be much higher than they are today.  And that's the best-case scenario--that the bubble in gold will burst! I WANT gold prices to decline, because that would mean trust in our global financial system has returned, that trade imbalances are mitigated, and fiscal deficits are vanquished.  The gold bubble will burst if/when all developed countries in Asia, Europe and the US will get their fiscal house in order, when stocks and real estate return to levels where they make economic sense...when the concept of sound money returns, and austerity, savings, and investment are rewarded--not punished by artificially low yields.  This also means letting zombie banks and reckless countries collapse.  Bad loans must be written down, with both borrowers and creditors taking a hit instead of being bailed out.  Of course, this will never happen because politicians have to answer to their entitled constituents, who demand something for nothing.  Which means the bailout mentality will continue until it can't continue anymore.  Bailouts entail ginning up the printing press, which is by definition, inflationary--despite denials by the Keynesians who only point to their sacred, but utterly fictitious CPI data.  And of course bad debtors will default anyway, only later and under much worse conditions.

Where does this lead us?  If that's the best-case scenario, what's my worst-case scenario?  The answer is gold and silver will be SPENT in barter, not sold for a profit.  Because in that financial Armageddon scenario, the USDollar would have collapsed and we'd be in an apocalyptic hyperinflation, at which point, you'd be suicidal to exchange your gold and silver for USDollars (or more correctly, Federal Reserve Notes--read the wording).  Why would you trade in a tangible asset for worthless paper?
There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.
– Ludwig von Mises

“The few who understand the system will either be so interested in its profits or be so dependent upon its favors that there will be no opposition from that class, while on the other hand, the great body of people, mentally incapable of comprehending the tremendous advantage that capital derives from the system, will bear its burdens without complaint, and perhaps without even suspecting that the system is inimical to their interests.” - The Rothschild brothers of London writing to associates in New York, 1863.
“Let me issue and control a nation’s money and I care not who writes the laws.” - Mayer Amschel Rothschild (1744-1812), founder of the House of Rothschild.

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