Categories: Base Metals / Energy / Precious Metals
Topics: General Base Metals / General Energy / General Precious Metals

An Intervew with Paul van Eden

 

As many of you know my investment letter was spun out of Paul van Eeden’s letter when he shut it down early last year.  Prior to that Paul and I had been working together for many years and I was a regular contributor to his letter.  Paul has a very keen and often contrarian sense of the markets and spends a great deal of time interpreting the underlying economic data to arrive at his own conclusions.  Needless to say, he has made some very perceptive calls in the past.  Given the current state of the world I thought it would be insightful to hear from him at the beginning of 2009.  What follows is our discussion of January 14, 2009.

EI: Last January at the Vancouver Cambridge Investment Conference you emphatically told everyone to sell everything but gold.  You didn’t make many friends at the time but in retrospect that was the best advice given at that conference or probably any other since.  What did you see that lead you to such a certain decision?

PVE: On January 18th, 2008 President Bush gave a speech in which he said "... there are also times when swift and temporary actions can help insure that inevitable market adjustments do not undermine the health of the broader economy.  This is such a moment.”  This speech culminated a series of unusual speeches from Fed Chairman Ben Bernanke, Fed Governor Mishkin, former Fed Chairman Greenspan and former Fed Chairman Volcker.  At the time secondary credit markets were already collapsing but there was something new afoot that spooked them.  It was obvious that something had gone wrong, something much worse than the market up to that point had factored in.

By the end of January it became clear what had happened: Commercial banks in the US in aggregate had to borrow more than 100% of their reserve requirements from the Fed.  This was clear and irrefutable evidence that US banks were in serious trouble, and if the banks were in trouble the whole financial system was vulnerable and credit to the economy would be affected.  In essence, the unsustainable practice of debt-financed consumption had come to an end.  That meant slower economic growth and financial recalibration which would inevitably lead to a decline in equity and commodity prices.

EI: What didn’t you see at the time, or what surprised you as the year wore on?

PVE: It was obvious that the US government would pull out all the stops in an attempt to prop up the economy, save the banks, and stimulate consumer spending.  That meant a quantum increase in government spending concurrent with a sharp decline in government revenues from taxes.  The US government therefore would be forced to dramatically increase its borrowing, or stated another way, the government was going to issue a lot more debt.

To put this in perspective, most people expect the 2009 federal budget deficit to be in excess of a trillion dollars.  There is currently about $6 trillion of federal government debt held by the public, which means that if the government had to borrow another $1.2 trillion this year it would increase the federal debt held by the public by 20%.  A 20% increase in US federal debt in one year is an extraordinarily large increase and should cause US interest rates to rise.

However, the opposite happened because an enormous flight to safety ensued. Capital flight to US Treasuries and Notes caused a decline in interest rates to historically low levels.  During November and December the US government was borrowing short-term money at a zero percent interest rate.  Buyers of those Bills were taking a return-free risk with their capital since there were still exchange rate and inflation risks associated with those instruments.

I do, however, believe that we have most likely seen the top for US bonds, notes and bills.  Even though interest rates may not rise as fast as I had originally anticipated, they are highly unlikely to decline from current levels.

EI: Will the 1-point whatever trillion-dollar stimulus package plus all the bailouts put the US on the road to recovery?  Will this work or are there still some serious landmines to watch out for?

PVE: The process of recovery has most certainly started but that doesn't mean the bad news is out of the way.  I think it's going to take a much longer time to recover this time around than what people are accustomed to.  There is an enormous amount of consumer, corporate and government debt outstanding, so the idea that we are going to see a rapid recovery on the back of even more consumer, corporate and government borrowing and spending seems odd to me.

Only governments will continue borrowing and spending.  The private sector is going to be forced to deal with existing debt in the face of slower economic growth.  That means less consumer spending, which is what has been driving the US economy for decades.  It has finally become apparent that Americans cannot consume their way to prosperity.

As consumption slows so too will corporate revenues and profits.  The landmines I still see lying in the road are corporate earnings.  While current price to earnings ratios may look attractive I suspect that earnings still have a long way to fall, and that means stock prices could still fall much further.  But that is likely to happen only after the New Year optimism wears off and we get another two quarters, or so, of declining corporate earnings.

Recessions, which are loosely defined as two consecutive quarters of declining economic activity, occur as a result of inventory buildup that has to be worked off.   Depressions, which are more than two quarters of declining economic activity, occur as a result of excess manufacturing capacity, often built on a mountain of debt, and take longer than a couple of quarters to absorb into the economy.  Fixing a massive amount of excess manufacturing capacity, which is precisely what we have on a worldwide scale, will also require many, many bankruptcies that are yet to occur.  Therefore, while I think we have already started down the road to recovery I also think it's going to be a longer and rougher road than what many hope it to be.

EI: How do these problems eventually get fixed?

PVE: Well, we already mentioned one prerequisite: bankruptcies.  Bankruptcies reassign the assets of production to more conservative, efficient and productive owners.  As that process continues, the foundations for new economic growth are laid down.  The burden of debt will also hopefully stimulate a culture of saving, as opposed to borrowing and consuming.  Savings constitute the capital required for economic growth and prosperity.  Contrary to the belief that we can consume ourselves to prosperity the truth is that we have to save and produce our way to prosperity.  The problems will get fixed as bankruptcies redistribute assets and people start saving again.

EI: You have been working with a proprietary measure of monetary inflation called Actual Money Supply (AMS).  I have included the most recent chart from your website below; what is it telling you? (readers can view all of Paul's articles and charts on his website: www.paulvaneeden.com)


(Actual Money Supply--AMS and, Actual Inflation Rate--AIR)

PVE: People have become accustomed to thinking that inflation means an increase in prices, but that is wrong.  Inflation is an increase in the money supply.  An increase in the money supply will always cause prices to be higher than they otherwise would have been but prices can rise and fall for reasons that have nothing to do with inflation.  For example, a shortage of flour can cause the price of bread to increase and that has nothing to do with inflation.  Similarly, a sudden increase in logging can cause lumber prices to fall, but that does not mean we have deflation.  At the moment real estate prices are falling because there was a construction boom driven by speculative demand.  That demand has now dried up leaving us with a glut of homes; hence home prices are falling.  But that is not deflation. 

Several different "measures" of the money supply exist and I believe they are all flawed.  Some do not include all types of money and others include items that are not money at all, such as money market mutual funds.  I prefer to keep things simple and define money as the sum of all currency in circulation (notes and coins) plus all deposit accounts at banks.  To my way of thinking money cannot be anything more, or less, and I call this the Actual Money Supply.

As you can see from the chart the Actual Money Supply has been increasing steadily for the past four years even though there was a temporary hiatus last year.  It shows us that we are categorically in an inflationary environment.  The Actual Inflation Rate, which is the monthly year-over-year change in the Actual Money Supply, is shown in red.  While volatile, the inflation rate is alarmingly high.  The average inflation rate from January 2006 to December 2008 is 8.13%.  For comparison, the average inflation rate during the 1970s, which is widely recognized as a highly inflationary period, was 8.32%.  It is just a matter of time before this monetary inflation starts filtering into prices.  If the economic recovery is not well on its way by then we could find ourselves experiencing rising prices and anemic economic growth, which would not be fun.

EI: I remember way back in about 1997 you published some articles on the gold price and its relation to the US dollar.  Since then you have developed a gold model that shows the fair value for gold in US dollars (included below).  What is it telling you and what is this model missing?

PVE: This model shows us the average annual value of gold in US dollars based on the relative inflation rate of gold to the inflation rate of the dollar.  Inflation of dollars debases, or devalues dollars and similarly, inflation of the gold supply through mining devalues the gold we have above ground.  I am simply applying the principles of inflation as they relate to all forms of money to gold, since I believe that ultimately gold is money.


(Spot gold price and Theoretical gold value 1970 through 2008)

This model is backwards looking, meaning it tells us the value of gold in terms of dollars based on what has happened.  The model is not intended to be forward looking or predictive.  Nor does it take into account short-term influences on the gold price, such as changes in exchange rates.  In fact, the model has nothing to do with predicting the gold price, it relates to gold's value in terms of dollars.  I use the model as a tool to know whether gold is overpriced or underpriced.  When gold becomes overpriced I sell what I have, or even sell short, and when gold is underpriced I buy.

Right now gold is overpriced by about $50 to $100 an ounce although I am not very concerned about that and I am still long gold.  You may recall that I expected interest rates to rise and they haven't.  Part of what is keeping a lid on interest rates at the moment is a statement by the Fed that it stands ready to buy US Treasuries and debt obligations in unlimited quantities to prevent interest rates from rising.  That is called monetizing the debt and when the Fed buys US government debt obligations it typically creates the money to do it.  Therefore monetizing the debt is highly inflationary.

The value of gold is determined solely by the relative inflation rates of dollars and gold.  Gold's inflation rate as a result of mining is relatively low, about 2%.  In the previous chart you saw that US dollar inflation is about 8%, meaning that the value of gold is rising at approximately 6% per year.  If the Fed actually does monetize US government debt then US dollar inflation should increase, and could increase quite dramatically.  That will in turn cause an increase in the value of gold vis-à-vis the dollar and I believe that is underpinning the gold price at the moment.  So even though gold is currently overpriced I am still bullish on gold.

However, given that gold is overpriced I am also very cautious in my trading and I would not be surprised to see the gold price temporarily fall by $100 to $150 an ounce.  Such a decline in the gold price would be a wonderful buying opportunity, if it occurred.  Recall that gold was about $700 an ounce only two months ago.

EI: Where do you see the gold price in US dollars and other currencies going over the next few years and why?

PVE: I expect the gold price to continue to rise steadily in proportion to the relative inflation rate of the US dollar versus the inflation rate of gold itself.  Based on current data, that means an average annual increase in the gold price of about 6% per year.  But if the Fed starts to monetize US debt I expect the gold price to be very forward looking and increase rapidly at a much greater rate than that.  While this is a possibility it is not necessarily a certainty.

EI: So you're positively inclined towards gold despite it trading above your model's fair value.  What would it take to get you to call your broker and buy gold immediately?

PVE: The Fed is talking about monetizing the Federal government's debt.  At this stage it's all just talk but it has put a floor under the bond market since nobody wants to bet against the Fed.  If we were to read about Fed purchases of US Treasuries I think it would have a rapid and significant positive impact on the gold price.  I would also like to see the result of those purchases show up in the Actual Money Supply; however, I am quite sure that the gold price would have responded long before the money shows up in the money supply.  So seeing the Actual Money Supply increase as a result of the Fed monetizing the debt would only be an after-the-fact confirmation.  By then the gold price would already have taken off.  This is why I am trading gold from a long position -- if the gold price takes off it could be very dramatic.  If the gold price rallies I will already be long gold. To answer your question: what would it take me to call my broker and buy more gold immediately?  A decline of about $100 dollars in the gold price would do it. 

EI: What are you researching now and where are you putting your money?

PVE: I am most active at the moment trading gold futures on the long side and US Treasuries on the short side.  Both positions are tricky, especially being short Treasuries, but I think both are going to pay off handsomely over the next five to ten years.  I am also buying companies that are trading for a substantial discount to their net asset value, when I can find ones that meet my criteria.  Mostly I am looking for companies that trade at a discount to their net cash in the bank and where I believe I have a reasonable chance to make a profit before management can piss the money away.  I am also in the market to build a new exploration portfolio, although I am being very patient and selective on that front.

EI: What are your views on the mining and exploration sector, and which would you consider buying?

PVE: The market is undoubtedly very different than it was anytime over the past ten years and I think it's going to be several years before risk capital returns in any meaningful measure.  I also think it's going to be years before base metals start showing upward momentum again because of the tremendous decline in demand that we are seeing.

Therefore I am not bullish overall about the mineral, mining or exploration sectors -- I think these sectors are going to be in the doldrums for a long time.  But that is also precisely the time to be buying a select few mining and exploration companies.  Investors with patience could be rewarded handsomely if they accumulate mining and exploration stocks while prices are low.  The basic strategy is not one I think is going to pay off in the short term, but experience has shown me that these stocks can rise ten-fold from their bear market bottoms to where they should be trading again when investor interest in mining and exploration returns.

I also know there are quality companies doing excellent exploration work and even though we may be in a bear market for resource stocks an economic mineral discovery will always result in profits for early investors.  I have for most of my investing career been investing in early-stage exploration and had the good fortune to be on the receiving end of several discoveries.  Most of those discoveries were identified by yourself and I give you credit for many of my investment successes.  I have the utmost confidence that we will continue to have success investing in mineral exploration and I intend to follow your recommendations in your newsletter.  It's worked thus far, why change?

And with that, let’s catch up on some of the stocks in our EI portfolio. ..............................(Viist Exploration Insights and become a subsciber to follow Bren't recomended stocks)

That’s the way I see it,

Brent Cook

Exploration Insights offers the sophisticated speculator independent and unbiased information analysis on the junior mining and exploration market.  It is written and produced on a weekly basis by Brent Cook, a veteran geologist and mining stock analyst. To learn more about subscribing to Exploration Insights visit our web site here https://www.explorationinsights.com/pebble.asp?relid=26

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Disclaimer

This letter/article is not intended to meet your specific individual investment needs and it is not tailored to your personal financial situation. Nothing contained herein constitutes, is intended, or deemed to be -- either implied or otherwise -- investment advice. This letter/article reflects the personal views and opinions of Brent Cook and that is all it purports to be. While the information herein is believed to be accurate and reliable it is not guaranteed or implied to be so. The information herein may not be complete or correct; it is provided in good faith but without any legal responsibility or obligation to provide future updates. Research that was commissioned and paid for by private, institutional clients is deemed to be outside the scope of the newsletter and certain companies that may be discussed in the newsletter could have been the subject of such private research projects done on behalf of private institutional clients. Neither Brent Cook, nor anyone else, accepts any responsibility, or assumes any liability, whatsoever, for any direct, indirect or consequential loss arising from the use of the information in this letter/article. The information contained herein is subject to change without notice, may become outdated and may not be updated. The opinions are both time and market sensitive. Brent Cook, entities that he controls, family, friends, employees, associates, and others may have positions in securities mentioned, or discussed, in this letter/article. While every attempt is made to avoid conflicts of interest, such conflicts do arise from time to time. Whenever a conflict of interest arises, every attempt is made to resolve such conflict in the best possible interest of all parties, but you should not assume that your interest would be placed ahead of anyone else's interest in the event of a conflict of interest. No part of this letter/article may be reproduced, copied, emailed, faxed, or distributed (in any form) without the express written permission of Brent Cook. Everything contained herein is subject to international copyright protection.