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 Expect short-term hesitancy in the upward movement
of the gold price until liquidity returns to the markets, says Frank Holmes,
CEO and chief investment officer at U. S. Global Investors and co-author of
the new book “The Goldwatcher:Demystifying Gold Investing” (John
Wiley & Sons). In this exclusive interview with the Gold Report, he
predicts gold will go to $1,000, even $2,000, over the next two years. A
growing money supply due to a change in government policies will help lift
some juniors out of their misery, too. Holmes advises selective nibbling
until conditions improve and names a few companies to consider.
TGR: Can you
start off by telling us what’s going on?
FH: Based
solely on global economic indicators, commodities should be in a cyclical
bear market with no bottom in sight. But there’s intense pressure on
policymakers to fill the deflationary vacuum that’s been created by
both Main Street and Wall Street. Main Street’s plummeting housing
prices stretched the limits of the financial system, but lawmakers in an
election year will find it easier to blame Wall Street than Main Street.
TGR: Both sides
are at fault.
FH: The abuse
of leveraging is the biggest culprit. Mike Milken spoke at a conference I
attended last week in Hong Kong. He said that at the height of his career he
was leveraged 4-to-1. Goldman Sachs now is leveraged 20 times, so a 5%
mistake would wipe them out. The combined impact of Sarbanes-Oxley, FAS 157
(mark-to-market regulations) and leverage abuse has cost New York its
position as the world’s financial capital. No one expected
this escalation of write-downs.
When Warren Buffett bought General Re Insurance in
2002 he warned about notional valuations because he tried to sell some of the
derivatives, and lost billions of dollars. He called derivatives
“weapons of mass financial destruction.” Everyone ignored him,
and the derivative market increased 500% in five years.
TGR: Wow.
FH: If you
make a 2% mistake in the $500 trillion derivative market, that’s $10
trillion. What’s $10 trillion? Well, the world’s total GDP is $50
trillion. The total amount of U. S. dollars in circulation is roughly $15
trillion. A 2% mistake wipes out 20% of the world’s GDP.
We’re actually experiencing huge
deflation—in housing and on Wall Street. It’s not inflationary
yet. The Paulson package is a stopgap measure that could lead to inflation.
This meltdown is just like 1974 or the Depression of the 1930s, not the 1987
quick crash. It continues to destroy confidence. Another thing that propelled
this meltdown to more disastrous proportions was the rule that removed the
uptick rule for short-selling.
TGR: What will
fix this situation?
FH: That’s
a good question. Adding untested regulations is dangerous, and the law of
unexpected consequences is often negative. The combination of Sarbanes-Oxley,
FAS 157 and the no uptick rule for shorting basically became toxic and led to
the destruction of Lehman Brothers and Bear Stearns. Also,
“ideas” like printing more money and the debasement of currency
do not solve the credit crisis and are not good long-term solutions.
The dollar’s not going to collapse due to loss
of Asian support. All countries will support the dollar. The reason is that
they can’t afford for it to fall too far because then suddenly the U.
S. would be exporting products and not importing. All the currencies will
slowly debase themselves against gold and keep the dollar as the currency for
global trade.
It appears we are now going through that inflection
point moving from deflationary forces to an inflationary cycle. We had a
little bit of run-up in inflation when oil ran to $150 a barrel, which was
very excessive. What didn’t make sense was the fact that gold
didn’t rise along with oil. On the historic 10-to-1 ratio, gold should
have gone to $1400 to $1500. That leads to suspicions that a few people were
manipulating the price of oil because gold failed at $1,000 per ounce. On
another note, it is important to remember policymakers will do everything in
their power to create liquidity and, historically, liquidity is bullish for
commodities. However, our research suggests it’ll take several quarters
before this will affect commodity prices.
TGR: Will the
market stagnate until this liquidity flows through and moves the commodities
up?
FH: You’ll
have to be a very selective buyer for another couple of quarters. The price
correction should lose downward momentum and create a “U” shaped
bottom as the capital markets begin to reflect the policies being
implemented.
TGR: When you
say the price correction will lose its downward momentum, do you mean this
wholesale sell-off of everything?
FH: Right.
TGR: We saw
yesterday that Goldcorp (TSX:G) (NYSE:GG) was down 16%.
FH: That
downward momentum will start to slow.
TGR: When you
say commodities, do you mean gold?
FH: Asian
economic activity has a big influence on the purchase of gold. At the London
Gold Bullion Traders Conference in Kyoto, I was amazed to find the magnitude
of the shortage of gold and silver coins. In Germany, they aren’t
having the crisis we’re having here, but Germans were lining up to buy
gold.
TGR: Do they
have supplies?
FH: No, but
they have gold in the kilo bars. Everything is sold as soon as they get it.
TGR: I tried to
buy some Swiss 20 Francs today and couldn’t find any.
FH: People are
paying a large premium for small coins, and the purchase of safety deposit
boxes is on the rise. People have been actually stuffing dollars in them,
along with gold. It’s not really a 1980-style mainstream panic. People
are continuing to buy. The growth of gold ETFs attests to that. Now let me
try to explain some of these huge price swings in commodities, equities and
emerging markets.
Your readers might be interested to know that banks
all have this software called VAR, or Value At Risk. It triggers an alarm indicating
a need for more capital due to escalating debt defaults. You’d think
that banks would go to their prime brokerage arm and rein in hedge funds
trading mortgages and de-leverage them because that’s where the risk
is. Your business model says, “I have defaulting mortgages, so I need
to be sure our hedge fund and prime brokers aren’t having similar
problems.”
TGR: Right.
FH: Well, the
banks reacted by calling every hedge fund and de-leveraging all asset
classes, equities, banks and commodities. So, starting August 12, 2007, some
of the S&P stocks moved 15% in a day internally. This same margin call
has now taken place about four times this past year. U.S. banks in Japan
yanked loans to small cap companies, so those guys were scrambling to replace
those loans. Situations like that are happening everywhere and they
illustrate the long reach of this credit crisis.
A lot of emerging marketing investors got their
noses bloodied when the U.S. called for its loans to be repaid. They will not
be so quick to repeat that mistake. This ripple effect is hurting businesses.
That is a concern that I heard over and over. Fortunately, the governments of
emerging markets have huge surpluses and are better equipped to handle this
crisis than they were in the 1990s.
All of this is good for commodities and gold rises
in step with commodities. When inflation erupts everywhere, then gold will
take off on its own with a bigger move.
TGR: When will
that happen exactly?
FH: Over the
next two years gold will be well over a $1,000, maybe running up to $2,000.
The number-one Asian analyst, Chris Wood, is advocating a 30% gold exposure
to institutions. Now, this is the number-one brokerage firm in Asia and their
research is excellent.
TGR: What’s
the name of the firm?
FH: CLSA-Asia
Pacific Markets. It recommends a portfolio allocation of 30% gold:15% gold
bullion and 15% unhedged gold stocks. When an analyst of his stature advises
putting 30% of your portfolio into gold, you have to take note. We tell our
clients to put a maximum of 5% into bullion and no more than 5% toward gold
equities.
TGR: Doug
Casey’s latest missive rounded it up to 30% too.
FH: The
significance here is that the institutional side is getting on board with
gold. That’s a big deal.
TGR: Because
the gold market is so small compared to the market caps these institutions
deal with, even a small change in percentage would make a huge difference.
FH: All the
brokers are getting their marching orders simultaneously. What happens is
that non-correlated assets begin to correlate as people seek liquidity. So
everyone’s saying, “I have to get cash.” It’s
important to remember that brokers were leveraged 20 times and low-income
house buyers were leveraged 99 times. This creates a chain reaction and
knocks down the commodities. Several of these hedge funds have blown up, and
if our holdings are similar to theirs, they’ve hurt us.
We went into this correction with a big cash
position back in June, and we never expected such a huge correction, but our
models were showing that it should be 20% to 25% cash. Then we start to
nibble as things get clobbered, but they continue to get clobbered.
TGR: Yes.
FH: Last week
the markets hammered every stock with liquidity. Many funds have been hit by
this problem. Margin calls are driving this. It has nothing to do with the
demand for gold or the supply and discoveries.
TGR: But that
should work itself out fairly quickly by the end of the year.
FH: It was
estimated that by the end of the year there would be $22 billion of resource
stocks coming out.
TGR: Do you
mean coming out of the hedge funds?
FH: Yes. Hedge
funds have been forced to shut down. It’s really interesting to look at
the TSE Venture Index. When the asset-backed paper problems happened last
summer, retail sponsorship dropped dramatically. The U. S. went through
something similar in February when suddenly the small caps and mid-caps
started losing liquidity. What we noticed was that the auction rate paper is
exactly ten times the size of Canada’s asset build paper crisis—$330
billion versus $33 billion. It was just before tax season, so a lot of
American investors had to scramble for cash by redeeming their equity funds
to pay their taxes.
TGR: Do you
follow Richard Russell’s Dow Theory Letters?
FH: You mean
regarding the relationship between the Transports and the Dow Industrials?
TGR: Yesterday
both were down so Dow Theory now confirms that we are in a bear market.
FH: Yes.
TGR: What
happens to gold stocks in a bear market?
FH: Whether
you have big deflation or big inflation driving the bear market, gold does
well. If it’s just a normal cyclical inventory recession or whenever
interest rates are above the CPI rate, gold doesn’t do well. Today, the
Fed’s funds are below the CPI rate and the printing presses are busy.
TGR: So, what
are we in now?
FH: I think
we’re at the tipping point moving from deflation to inflation.
TGR: So,
we’ve been on the negative side of that.
FH: We saw
gold run to $1,000 twice because of deflation, not inflation. Massive
liquidations are deflationary. Collapsing housing prices are deflationary.
The price of oil running up was inflationary but it was triggered by the
dollar deflation and gold moved with it. In the '30s, when you had a big
deflationary cycle, gold was the best asset class. In the '70s, when you had
a big inflationary cycle, gold was the best asset class.
TGR: Right.
FH: In the
'90s when there was no big inflation or deflation, gold just meandered along.
TGR: So when do
you think we will reach that tipping point from deflation to inflation?
FH: The money
supply has basically been flat for the past three months. The correlation of
commodity price action and emerging market money supply has an R-squared
value over 80—highly correlative. We track the G-7 countries versus the
E-7 (the seven most populated emerging countries in the world with available
data) and track their money supply. The money supply has not been growing
rapidly. We need to get the money supply up and this will happen with the
$700 billion bailout. So, we’re going through a transition over the
next couple of months.
TGR: When will
gold respond?
FH: There’s
been a six-week lag with the money supply, the same with NASDAQ. If the money
supply spikes, there’s a 70% probability that within six weeks the
NASDAQ will start to rise.
TGR: Why would
an increase in the money supply impact NASDAQ?
FH: People
have more cash to spend.
TGR: So
they’re moving into the NASDAQ?
FH: Yes. The
money supply has one of the highest correlations to the gold commodity as a
whole. When you look at stocks individually, the number-one driver is the
production per share growth. After that, it’s cash flow, and then
reserves. You can eliminate 80% to 90% of all the noise by calculating
production and the cash flow.
TGR: What would
you tell someone who has just inherited a million dollars?
FH: I’d
put 5% into gold bullion and 5% into unhedged gold stocks.
TGR: Unhedged
producers?
FH: Yes, and if
you want to go down to the smaller caps like Jaguar (JAG. TO), that’s where you get your biggest potential
returns.
TGR: Can you
share a few names on your list of unhedged gold producers?
FH: We like
companies that have a royalty business, such as Royal Gold (RGLD). We also look at those with the strongest
per-share-growth rates coming over the next 12 – 18 months. That list
includes Agnico-Eagle Mines (TSX:AEM), Kinross Gold (KGC-NYSE; K-TSX), and Goldcorp—all of which have very healthy
growth profiles relative to the Newmonts of the world. Goldcorp isn’t a
pure gold play, because it also produces a high percentage of base metals.
But we expect that within two years those base metals will really start taking
off.
TGR: Is that
prediction based on anticipated growth in China?
FH: Yes. China
has structurally gone through a quiet phase, but the government has policies
in place that are designed to invigorate growth. As that growth starts to
pick up steam over the next six months, you’re going to see increased
demand for the basic commodities. Of course, the economy is spending a lot of
money for infrastructure right now, and that might put a temporary lag on
commodities.
TGR: But you
believe China’s growth will drive the commodities market higher?
FH: Yes. The
credit crunch created by the collapse of U. S. financial institutions will
slow things down for a while, but ultimately, China will grow.
TGR: What other
companies do you like?
FH: Unless
they have two grams of gold (per ton) or a million ounces, junior explorers
have been drifting lower and lower. Historically in situ reserves have
traded at one-tenth of an ounce of gold. So, if gold is $600, then your
reserves are worth $60 per ounce. When gold was $300, they were worth $30.
That was the model for determining a fair market cap for junior explorers.
With gold at $850, these companies should be worth $85 per ounce of reserves,
but they’re not. This amazes us. And when one of these companies is
bought out, it’s usually paid more than the ten times ratio. But
valuations are now drifting down to $40 and $35 per ounce. So the market is
basically valuing a company that has 8 million ounces as if it had only 4
million ounces.
TGR: This is a
short-term phenomenon, right?
FH: Yes.
TGR: So, when
this situation changes, how quickly will producers and majors start buying up
the juniors?
FH: That’s
a different point. The seniors are going to buy only those juniors that have
two grams of gold per ton or a million ounces. The other juniors will just
work their way out of the system or go bankrupt.
TGR: What other
criteria do you use to evaluate juniors?
FH: We ask
some simple questions:Is the CEO technically competent? That is, is he a
geologist? If not, that may be okay, but does he have a broad network to make
up for that lack of technical knowledge? Does he know the newsletter writers,
like Doug Casey, for instance? Does he know the investment bankers?
We’ve found that if the CEO does not know the
Street, and doesn’t know the newsletter writers, it doesn’t
matter if he’s a geologist or an engineer. There’s going to be no
liquidity in the company’s stock, unless there is a multimillion ounce
discovery with a grade of greater than 2 grams per ton. But if you have a
company whose CEO knows lots of newsletter writers, gets lots of coverage,
knows the value in the Street and gets research for it, that company is going
to have a higher price-to-book valuation, which makes it a much more
attractive investment.
TGR: Anything
else you look for?
FH: Financing
is crucial. Companies that are rapidly spending money are going to run out of
cash in about six months. The market undervalues them until they have
financing in place.
TGR: Can you
give us a few companies on your list that meet your criteria?
FH: Moto Goldmines (TSX:MGL), which is in the Congo, is in that category, though
they face geopolitical risks. The company has more than 10 million ounces and
more than five grams per ton. Another one is Gabriel Resources (GBU:TO), which has a large asset in Romania.
TGR: Both of
these companies have some geopolitical risks associated with them.
FH: They do.
But if they satisfy the criteria, these are the ones that the big mining
companies will be acquiring.
To learn more about investing in natural resources,
you might want to take a look at industry veteran Frank Holmes' new book, The Goldwatcher: Demystifying Gold
Investing. Holmes is CEO and
Chief Investment Officer of U.S. Global Investors, Inc., a registered
investment adviser that managed more than $5 billion in 13 no-load mutual
funds and for other advisory clients as of June 30, 2008. U.S. Global
specializes in the natural resources, emerging markets and global infrastructure
sectors. Its funds have received numerous awards and honors during
Holmes’ tenure, including more than two dozen Lipper Fund Awards and
certificates. Holmes is a much-sought-after keynote speaker at national and
international investment conferences. He is also a regular commentator on the
financial television networks CNBC and Bloomberg, and has been profiled by
Fortune, Barron’s, The Financial Times and other publications. In
addition, Holmes was selected as the 2006 mining fund manager of the year by
Mining Journal, a leading publication for the global natural resources
industry.
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