The Gold Report: At the end of 2014 you described yourself
as a reluctant bear on the U.S. stock market. Why?
Joe McAlinden: I said "reluctant" because I really don't
like being negative on U.S. equities. After all, stocks go up two years out
of three, and so the odds are against betting on a big decline. Nevertheless,
after five decades at this game, I have come to believe there are rare moments
in market cycles when prudence dictates going against the crowd. And the
conditions that I observed at the time had me very concerned about the
sustainability of this rally without a big correction. For a while that
position seemed out of touch as stock prices surged to all-time highs during
the first five months of 2015, but the S&P 500's 12% correction from its
peak in May now suggests otherwise. Based on extended valuations, lagging
small caps and a more hawkish path toward the normalization of interest rates,
the really big decline I have been looking for is, in my view, still lurking
dead ahead.
TGR: If your prediction is true, how can investors protect
themselves and their portfolios?
JM: There are always some things that go down in a rising market or
up in a falling market. . .or at least go up or down by less. Value stocks,
for example, have performed very poorly relative to growth stocks for eight
years, but we believe this is in the process of reversing. More recently,
there are sectors of the markets that have declined significantly more than
the broad list of U.S. equities: Energy has been clobbered along with other
industrial materials, and precious metals have been annihilated, with the
price of bullion down 40% and gold miner stock prices down 80%.
TGR: When we talked in September, you said you were turning into a reluctant
bull on hard assets, particularly precious metals and especially gold. Why?
JM: Decades of experience have taught me that trying to catch a
falling knife is a dangerous undertaking. Nonetheless, there are a number of
reasons why overweighting hard assets like gold looks to me like the right
decision at this juncture. Here are four reasons:
Buy Low/Sell High: Gold has been in an almost
continual downtrend for over four years, aggregating to a 40% decline while
the S&P 500 has soared over 60%. That alone is enough to get an old,
opportunistic "buy low" value shopper intrigued. The pattern is
similar for other precious metals and, indeed, for oil and numerous other
"hard" commodities. In this report, we will focus on gold, but most
of the points pertain to other precious and even non-precious metals as well.
Fiat Money Debasement: Following the global
financial crisis, major central banks around the world resorted to an
unprecedented expansion of their balance sheets to prevent their respective
economies from plunging into a deflationary spiral. In the U.S., the Federal
Reserve more than quadrupled its balance sheet by buying U.S. Treasury bonds
and lots of debt backed by real estate securities. Other major countries have
followed suit in varying degrees, most notably Europe and Japan.
The hockey-stick explosion in central bank balance sheets has been an
extension of a long-term uptrend. While gold's value has grown in the long
term, along with other precious metals, since the U.S. Treasury moved off the
gold standard in 1971, the value of gold has not grown anywhere as much as the
quantity of dollars that it once legitimized. Gold is now priced at nearly
seven times its 1971 price, while assorted measures of U.S. fiat money
creation have exploded up to 38-fold over the same period.
The table also shows where gold would be if it had increased in proportion
to the monetary, debt and inflation data over the past four decades. This is
NOT a list of projections; rather, it is a hypothetical exercise. If gold
experienced the same increase as currency in circulation, its price would be
almost triple what it is today. Even more dramatic, gold's hypothetical
price—if it had followed the trend of the monetary base—would now be a
whopping $6,663 an ounce ($6,663/oz). The only series that has increased less
than gold is the consumer price index (CPI).
The inflation that might have been expected to result from this massive
money printing has not shown up, at least not yet. Meanwhile, one could say
that if gold moves to converge with the CPI, it could fall by around $300/oz.
But, if gold converges with these monetary and debt series, its price could
rise to between $2,000 and $6,000/oz. For the moment, I am inclined to
project that gold prices could at least double over the next few years. I
like those odds.
Rising U.S. Rates: Conventional wisdom is that a
hike in interest rates is going to hurt gold, but that is not borne out by
past data. Indeed, most pundits who had been opining on the precipitous drop
in the price of gold have cited the imminent tightening of monetary policy in
the U.S. as a reason why gold may continue to decline. Even the very recent
strength in gold has been attributed to postponement of the first rate hike.
But that reasoning defies the lessons of history, which show that it is not
axiomatic that when rates are hiked, gold slumps. Sometimes it has but
sometimes it has not.
Also, it should be remembered that over the past four years, gold has lost
almost half its value in the face of zero interest rates and the easiest
monetary policy in history. Indeed, while perhaps counterintuitive, the
historical evidence points at times in the opposite direction from
conventional wisdom. Since gold was freed from its fixed value in 1971, there
have been five major tightening cycles. Gold rose dramatically during three
out of five rising rate periods. In the fourth, it rose then fell. Only in
the fifth rising rate cycle, in the late 1990s, did it decline.
The FX Factor: Because U.S. investors tend to think of
gold as priced in dollars, the four-year downtrend misses important trends
elsewhere. One by one, major currencies have fallen in value relative to the
dollar. Virtually all of the four-year decline of gold is a mirror reflection
of the rise in the exchange rate of the U.S. dollar, or—looked at the other
way around—the profound weakness of most currencies versus the dollar. If one
looks at the price of gold denominated in certain other currencies, the bear
market turns into a bull market. Some of the most glaring examples can be
found among the BRIC and CIVETS, and even a major currency like the yen.
Thus, in countries that have experienced the greatest weakness against the
dollar, gold is actually at or close to an all time high!
The extraordinary period of strength in the U.S currency may now finally
be ending, marking a bottom for gold and reversal of its performance going
forward. The economic data for the Eurozone is slowly improving. China will
undoubtedly resort to additional stimulus to bolster its economy. The
supply-demand picture for energy may also be finally starting to reverse, and
there is a positive feedback loop at work. Recent news that major oil
producers are ready to meet to discuss global oil markets could be a turning
point, and Russia's emergence as a new power player in the Middle East will
likely strengthen OPEC's hand and resolve to reverse prices.
TGR: What does this mean for the equities related to the
companies producing precious metals?
JM: Mining stocks have fallen over the past four years by
twice the percentage decline of bullion. These are operating businesses, and
like other commodity-related companies, most of their costs don't go down
when the selling price of their product does. But the same should be true on
the way back up. If miners move back to their 2011 highs, they would rise
fourfold. We think it is time to add the gold miner equities to our list of active
themes.
TGR: Thank you for your insights.
