Ian McAvity on the Economy: "Cockroaches are Coming out of the Closet"
Source: The Gold Report††(3/5/08)
The Gold Report caught up with Ian McAvity, editor of Deliberations On World Markets, a technical newsletter now in its 35th year, covering precious metals, currencies and global equity markets. McAvity doesn't pull any punches about his view of the economy: "thereís a new cockroach coming out into the daylight every week."
TGR: How about giving us your overview on the markets for the next 12 to 18 months, and a little bit about the short term?
IM: In the past month or so we have learned about another layer of credit problems that resulted in UBS taking a $14 billion write-off, and nobody had ever heard of that kind of credit until then. Itís a different form of credit derivative. Basically because of rating changes, they took a $14 billion write-off, and then later in the day they indicated that $120 billion of that stuff was still outstanding.
Itís the same week by week; thereís a new cockroach coming out into the daylight. Probably the best call was what I made last summer when the subprime first hit the fan and the Fed really responded to it. All the talking heads of television immediately said, ďOkay, the Fedís dealing with the problem, so consider it solved.Ē The headline in my newsletter was ďKilling the First Cockroach Never Solves the Problem.Ē Thatís why Iíve been referring to them as the cockroaches surfacing; every couple of weeks or every month we get a new one.
And nobody knows how deep this hole is. The ministers of finance seem to think itís $400 billion. A number of people think itís more like $600 or $800 billion. The talking heads are talking about the fact that the problem is now out there and the marketís discounted because the banks have written off $150 billion. When is the rest of it going to get written off?
My concern internationally is that we havenít heard a peep from the Japanese banks. And Japan basically has had the lowest-cost capital on the planet for the last decade or so. Thatís where you get all this yen carry trade, where people borrow at very cheap interest rates from Japan to make external investments. Typically, when the bubble is bursting, ultimately itís the lender of the last resort whoís going to end up eating an awful lot.
Whatís critical here is that Japanís fiscal year ends March 31, so between now and then, my guess is that a number of auditing firms and a number of Japanese bankers are engaged in some sort of a death wrestle. What are the write-offs going to be? Theyíve been living in denial for the last decade. And denial is not just a river in Egypt; itís policy. A nasty series of surprises from Japan could quite suddenly reverse the recent strength of the Yen, rebound the Dollar and indirectly contribute to a gold price setback.
TGR: So, where are we today and where do the charts show you a black swan?
IM: Basically, if people didnít like the leg that the S&P took Ė dropping somewhere between 15% and 20% between October and January, depending on how you measure it Ė I think weíve got another two legs like that coming. In essence, that first leg was really putting in the top and making the initial breakdown into a full-fledged bear market. The first phase of a bear market typically is greeted by denial. Then the second phase would be when you try to price in reality. The third and terminal phase is the capitulation, where people say, ďIím never going to buy stocks again in my life; the brokers are crooks.Ē To me, weíre just in the transition from denial to reality.
TGR: Do you think each one of those legs down could be 15%?
IM: If youíre lucky. The stage is basically set for what I would consider a crash-like environment, particularly given that they no longer have the up-tick rule for short sellers. So you could get a waterfall decline going one of these days, and some hotshot hedge fund manager can throw in an extra $10 or $20 billion at it to try and compound. In free markets, theoretically at least, heís perfectly free to try and do it, and the mechanisms are now there to enable it because theyíve removed all the collars. So everything that was put in to make sure 1987 didnít happen again has now been removed, so welcome to 2007 plus.
In my view, in retrospect weíll be talking talk about the bear market that started in July of 2007 and was particularly ugly. It could be over in a 12-month period, but the damage is going to be really, really brutal.
TGR: By really, really brutal, are you saying we could be down another 40%?
IM: Yeah, 30% or 40%. Let me put it this way, 50% from top to bottom would match the bear market we had in 2002, or would match í73 and í74. And itís arguable that the credit mess thatís behind all of this is a hell of a lot bigger than anything weíve ever seen before.
The biggest problem a lot of people have, I think, is one of perspective. If you think of it, the economy is roughly $14 trillion; the total market cap of the stock market is about $16 or $18 trillion. The total credit market is $48 trillion. These are all trillions, not billions. But amazingly the credit market is about three times the size of the stock market, and on top of that youíve got about six times that amount in derivatives that nobody knows how to measure.
In a sense, the stock market is the tail of the dog. Itís the dog that is getting run over by the car; we donít quite know what the tail is going to do. Just watching the combination of Paulson and Bernanke week by week in front of television cameras, itís increasingly clear that they havenít got a clue. Theyíre basically reacting to whatever the daily scare is, professing theyíre going to fix it. I am a firm believer in the old Ronald Reagan adage that government isnít the solution to problems; itís typically the cause of them.
I couldnít get much more bearish, in case you hadnít noticed.
TGR: Right. So what do we do with our money?
IM: For the typical American, you go directly to Treasury Bills. The dollarís losing value; youíve got a negative cost to carry, but the value of a Treasury Bill is thatís the final form of paper that the government cannot tinker with. Because the 91-day T-Bill auction is what keeps the wheels of the system turning. If you had a one-year note, you might suddenly discover some sort of emergency declared and be told that your one-year noteís now a five-year note. They couldnít possibly do that with a 91-day T-Bill or the system comes to a halt.
I keep thinking back to the wisdom of Jim Benham, who originally worked in the Fed and then founded the old Capital Preservation Fund. He ultimately sold it to American Century; I am not sure whether they still follow the policy. But I always remember Jim speaking to audiences in the í70s emphasizing that you want to own a direct T-Bill. You donít want a swap or an option or some piece of paper from somebody else between you and the Treasury. He was ahead of his time, but that was the cleanest piece of paper that existed. In my mind, this is exactly the environment where an attitude like that should be taken.
When I get people saying, ďWhy should I own a Treasury Bill; itís only going to pay me 2%, and thatís taxable?Ē the point I make is that the Treasury Bill is 100 cents on the dollar of buying power when everything has fallen 50%.
IM: When youíre buying everything at half price, then what was the yield on the Treasury Bill? You donít buy them for yield; you buy Treasury Bills to stand still when everything else is melting down.
TGR: Okay. So youíre not even buying gold here?
IM: Letís put it this way. As the old-fashioned gold bug, Iím not buying it here; I am still holding about two-thirds exposure. You know, two-thirds of what I would consider my full exposure, and my full exposure is a lot heavier than most people should have, because Iíve been in the business for so long.
TGR: Thatís you. What about for our readers?
IM: Basically whatever they think of as their full exposure, I would not have full exposure right now. In terms of gold itself, you just had a $300 run in five months. Itís been a tremendous run; it has huge implications for the long-term future. But if somebody is looking at gold now, is their blood pressure going to go up when gold goes down $150? If gold goes back down to $750 or something like that, are they likely to panic?
Unfortunately, a lot of the newer players will. Weíre vulnerable because the change of character really came when gold broke through that $780-$820 level. And in a stock market crash, basically everything goes down with it; itís quite possible you could see gold come back down under $800. Yeah, Iíd be a buyer then; well, letís put it this way Ė I would add to positions then. I wouldnít be chasing it over $900.
Similarly, the gold mining shares. Youíve already got a technical divergence where the shares have been acting very, very badly relative to the metal ó both on a short- and a long-term basis, particularly badly since the middle of January. Historically, if you go back and look at it, when the market takes a real hit, the gold shares take a big hit. And the gold shares are not cheap relative to the rest of the market at this point. Theyíre a bit stretched. Theyíve got plenty of room to take a big hit.
And the difference is in the stock market, itís going to be some time repairing the damage. When the gold shares take a big hit, Iíd be quite an aggressive buyer of them because that will be a correction within a bull market, a major secular uptrend in gold. Whereas in the stock market, theyíre going to have to build a base, and itís going to be a long time before the stock market comes back.
TGR: What kind of timeline are looking at?
IM: I think weíre in a crisis that is going to come to a head between now and May. The credit fiasco thatís going on at this point is almost like a whirling dervish gathering speed. Youíve got the Japanese year-end on March 31, and obviously youíve got a lot of quarter-ends and year-ends coming up within the U.S. financial system at the end February and end of March.
In theory, you have to mark to market, but how do you do that when there is no market? Yeah, you mark the model. Well, the models have proven to be broken. So youíre now dealing with mark to myth.
A couple of lawsuits against a couple of boards of directors ó I saw one even against some of the audit committee members for Citigroup ó just one or two of those suits being filed is going to get everybodyís attention, so the write-offs are going to start getting pretty serious. I wouldnít sit on the board of an American bank right now for all the tea in China.
TGR: So between now and May is when you think we could have a 40% drop?
IM: Yes, weíre basically in what I would call crash or pre-crash mode. Itís the credit debacle thatís going on, and the irony of it is that itís dragging the economy down. Theyíre still debating whether weíre in recession or heading into recession, and whether Bernanke can cut rates low enough to turn the recession around. If you look at the growth of credit and the growth of GDP in the U.S., the bigger problem is that it now takes about $5.30 of new credit to add $1 to GDP. Thatís about three times what it was 20 years ago. If the credit markets are basically choked, where is the new credit coming from to fund any growth in GDP at all?
So then Washington had the brilliant idea of mailing out tax refunds equal to 1% of GDP. So that we can try to avoid a recession? So here they are, theyíre going to mail out $170 billion. If they were smart and really want to get that money into the economy spent at retail, they should be dropping $5 bills in Wal-Mart parking lots, not putting it into the banks. Drop money in a Wal-Mart parking lot and it will get spent. If you put it into a bank youíre filling the black hole.
TGR: Is there anything we can do to avoid this impending disaster?
IM: Iíve said for years that ultimately they will try to print their way out of it; effectively go into a hyperinflation mode. Iíve always argued that it would take a deflationary accident ó essentially a crash in asset values ó to precipitate that. Itís that deflationary crash in asset values right now that I think is underway. Youíve got it going in houses. Somebody sent me an article that now one of the biggest difficulties is in one of the more arcane industries, the recall industry. They canít get enough drivers to repossess cars. People are forgetting that most of that automotive debt is also floating around in various collateralized debt obligations paper. We havenít even heard about car payments being defaulted on yet. At the moment, weíre only talking about mortgages Ė but weíve got credit card balances and car payment balances too. Basically, we have a generation thatís been living on debt, and the debt machine is in the process of shutting down.
Itís a really scary scenario. I recently published a very long-term chart of the NASDAQ Bank Index going back to the 1970s. What that chart suggests to me is the reversal of the secular trend that dates from that era of 1965 to 1975 has basically rolled over during the last couple of years and broken. The inference I draw from that is the modern credit market, the modern financial system as we know it, is probably going to come out on the other side of this very different. I donít think credit is going to be as readily obtainable. I donít think the financing is going to be there for an awful lot of stuff. In essence, itís going to result in a significantly lower standard of living for some time.
TGR: You had started to talk about the only possibility is if the government continues to print.
IM: That effectively is the hyperinflation solution, or the inflationary solution that inevitably leads to hyperinflation.
TGR: Then you donít want to own gold. You want to own tangibles.
IM: In the longer term, you definitely want to own gold and tangibles.
TGR: What Iíve been hearing is if weíre not going to have a crash by May, weíre going to have a crash in 18 months, because the government is going to do anything and everything to print as much money as possible, and to once again avoid it, avoid it, avoid it. This crash mode just becomes much larger and then again there is the black swan. It surfaces. Other folks are thinking this is 18 months out. Thatís what Iím trying to get a handle on.
IM: The key to the world of gold? Whether Iím right in terms of the next few months or others are right and it takes 12 to 18 months, itís that precipitating crash that then leads to inflate, inflate, inflate Ė oops, hyper. And thatís when they start throwing money at everything.
TGR: Thatís when they go into warp speed.
IM: Thatís when youíre putting gold up into the $2,000 or $3,000 or $4,000 neighborhood, Pick a number. At that stageóand the line I use in all of my speechesóan ounce of gold is an ounce of gold. The price of gold is just how many pieces of paper it takes you to throw at me to persuade me to give you some.
Yeah, every time I talk about gold at $3,000 or $4,000, I tell an audience, ďDonít salivate at the prospect. Youíre not going to like how it gets there.Ē The same with a barrel of oil ó a barrel of oil is a barrel of oil. And I like to ask an audience, ďWhatís a dollar?Ē Oh, itís a promise backed by a whole bunch of lying politicians.
TGR: Isnít the government printing money like crazy now?
IM: I believe so, but I donít even track the money supply numbers they publish, because they get revised so frequently, and in my mind theyíre so misleading that I really donít know what they mean. Once a quarter they publish an assortment of series of debt, and debt is a pretty hard number at one point in time. Itís a little bit like a balance sheet. It may have changed the next day, but at least I am getting something that is relatively consistent. Thatís why I tend to watch the growth of new debt, literally on a quarter-by-quarter basis.
In a lot of ways, the rest of it is a lot of noise. The other way to measure whatís going on are the credit spreads Ė the spreads between T-Bills or Treasury bonds and LIBOR, which is a market rate, except itís no longer a free-market rate because now youíve got the Feds throwing money over there trying to manipulate that rate.
TGR: Assume for a moment your view doesnít work out. We buy Treasuries. With this money being printed, but no crash coming, what would you see gold and gold stocks doing?
IM: The stocks will continue to lag the metal, I think. Basically, the managements of the gold mining companies have not done their shareholders any good over the last couple of years. The creation of the ETF has created real competition for their shares. Their shares are still pretty fully valued, but every time the shares start to move, they whack the shares with new share issues because itís a very capital-intensive business and theyíre perpetually raising money.
And then youíve got companies out there I basically call ďdeal junkies.Ē They continue issuing shares and engineering takeovers so they can get bigger and bigger. The problem with ďbigger and biggerĒ is over time, a number of companies have really reduced the quality of their reserves. Theyíve essentially lowered their grade. And theyíve all demonstrated a complete inability to cope with higher energy prices, and as a result, they havenít maintained much control over their costs.
So in theory, one buys gold mining stocks for leverage on the commodity price, but in point of fact, the shares of gold today are trading at lower multiples of gold price than when it was $250. The gold price has almost quadrupled; the gold shares have kept up with it but they havenít outperformed it.
TGR: But when we get into that third, final leg of that gold bull market, everything is going to fly.
IM: Oh, yeah, everything will be going crazy at that point. Put it this way ó I lived through the last one. Bear in mind that once it got going, the whole thing was over in about four months. Be careful what you wish for. I donít plan to wait another 20 years for the next one.
TGR: But suppose we get to the situation where we donít have the crash and the money that the government is printing is working its way into the system. Where do you see gold and gold stocks in that case?
IM: I think thereís a lot of speculative capital in the gold market right now. Itís not what I would call gold investment flows in the conventional sense. Youíve got massive amounts of money that are computer-trading on momentum, and thatís in the gold market as well. Itís much larger in the S&P and the stock market, but itís in all of the commodity markets as well.
The commodity markets, in that context, are a lot less liquid. And youíve got a natural imbalance between supply and demand, particularly with the rollbacks of supply in South Africa. Similarly with the apparent capping of Washington Agreement/Central Bank sales. Your supply is relatively contained, which makes it as bullish as you can ask for. Youíve got Japan, China, India, the whole world sucking up gold; that by itself was enough to put the price up.
But by that youíve also attracted billions of trading pool money from hot money. And itís the hot money that worries me. You know, you have a one-day crash of 10% on the S&P, every marketís going down. And itís basically because in essence the computer that trades that particular fund just says, ďSell whatever has a bid.Ē
Bear in mind that weíre getting into a period of substantially greater volatility. As a stock market indicator, we used to get really excited whenever the upside-downside volume was a 9:1 ratio. Invariably it happens on sell-offs because fear is a more urgent emotion than greed. So whenever you had a 9:1 day, that was really pretty meaningful. To put this in perspective, in the period of 1994 to 2000, we had a total of 15 of those 9:1 days, in a space of seven years. Weíve had 32 of them in the last year.
TGR: That many, really?
IM: Yeah. Itís absolutely mind-boggling with everybody in, everybody out. And part of it is a function of virtually no transaction cost. Everybody is sitting there with a computer and pushing buttons. Weíve got a generation of traders who grew up playing computer games. They went to Harvard, and now theyíre running a hedge fund, and theyíre still playing computer games with bigger chips.
But itís basically this period of extreme volatility that really worries me, and yet thereís still so much complacency. Bernanke or Paulson gets out and says something to try and smooth the ruffled feathers. The other day, Warren Buffet says, ďI will become the backup insurance to all the monolines.Ē The market goes up on the basis of it, everybody crowds in, and suddenly youíre up a couple of hundred points on the Dow just because Buffet made a proposition. Itís absolutely insane. To me, this is the ultimate. The big immediate threat is whether Moodyís is going to cut the credit rating of a couple of the insurers. So Buffet comes out with a proposal that heíll be the backstop insurer behind them. Nobodyís questioning the fact that heís the major shareholder in Moodyís. So effectively, Moodyís threatens to cut the rate, Buffetís standing there saying, ďIíll solve your problem for you, and if you donít take my offer, I will call my pals at Moodyís.Ē
TGR: Exactly. But heís saving his country. What is your thinking about two stocks we know you've been involved with, Central Fund of Canada Limited (CEF.AMEX; CEF.A. TSX) and Central Gold Trust (GTU -AMEX:TSX GTU.UN; GTU.U)?
IM: With the Central Fund of Canada weíre now up to about $1.6 billion. The holdings are a physical ratio of 50 ounces of silver for each ounce of gold. Thatís been the same ratio for more than 20 years now. Iíve always been attracted to the silver mix with gold because silver tends to become poor manís gold when we get into a frenzied market. It produces the additional leverage on the gold price for what I would call gold sentiment. Basically, CEF will reflect the metal price.
TGR: Whatís the premium right now?
IM: It trades around 8% premium currently. The premium range since the launch of the ETFs seems to go between 2% and 3% on the low side and sometimes 10% on the high side. Before the ETFs, the premium used to get as high 20%, 25%, and even 30% on a couple of occasions.
The ETFs were using Central Fundís premium as a marketing tool. The difference is we converted Central Fund into a specialized bullion holding company to become the first stock exchange tradable bullion proxy. We did that in 1983. The ETFs came along 20 years later.
Central Gold Trust is a lot smaller; itís about $160 to $170 million now, and it tends to carry a smaller premium. It is invested only in gold, so it has a little less volatility. I like to point out that it also has less liquidity, which on down days in the gold market could be quite attractive, in the context where you put a bushel basket under the specialist, under the market, and hope to catch some on a down day. Because if you look at the intra-day ranges, there are buying opportunities from time to time. But Iíd never buy them on an up day in the gold market.
TGR: Any other stocks you care to mention?
IM: Iím not a stock picker per se, but in terms of the major gold stocks over the last several months, Iíve been pointing out that the gold stock that all the gold bugs hate is in fact the strongest of them all Ė and thatís Barrick. Barrick has been outperforming.
And on the other side of the coin, itís looking increasingly prescient that Wayne Murdy, Pierre Lassonde and Seymour Schulich all left Newmont over the last year and a half, because Newmont is acting not well at all. Iíve seen some analysis that basically says they wonít really be turning around for a minimum of 18 months, maybe longer. And because of their size, theyíve also got, in a sense, geopolitical risk problems around the world. Theyíre getting beaten up a little bit in Indonesia right now. They were beaten badly in Uzbekistan. If you get the gold price up to $1,500 or so and have a couple of elections in South America, they may have problems there. So, whereas I once was rather partial to Newmont, Iím not any more.
TGR: What about Goldcorp?
IM: Goldcorp is such a different entity now. I loved the old Goldcorp before Wheaton, when it was the Red Lake deposit basically, because that was the greatest deposit. Rob did a spectacular job. Wheaton I was never terribly partial to. It expanded the thing tremendously. Then subsequently the deal with Glamis has completely changed the company. Iím not a big fan only because Iím yearning for the past; I know a lot of people who have a great deal of respect for it. The recent sale of Silver Wheaton probably makes some sense. But in essence, it becomes more of a development company because I think that most of that money is going into expanding the mine in Mexico.
But largely by process of elimination, Goldcorp is going to be one of the leading stocks. The industryís consolidated to such an extent that you havenít got much selection.
TGR: What about the chart on Goldcorp?
IM: I am still concerned by the fact that it hasnít managed to get above its 2006 high. It has made higher highs lately, so relative to the South Africans, it looks good. The chart isnít anywhere near as good as Kinross or Agnico-Eagle.
TGR: Or Barrick
IM: Or Barrick. Well, Barrickís the number one gold stock. The sad part is that Barrick isnít included in the S&P 500. None of the gold stocks except for Newmont are in the S&P 500. So all the index money flows support Newmont and nobody else. But, yeah, basically Barrick, Kinross, Agnico are the healthiest. Buenaventuraís got a good-looking chart, but Iím not as comfortable with South America.
The other one that is getting a lot of attention is Yamana, but it makes me a little bit nervous; in part, the president of Yamana keeps doing interviews in which he talks about Ian Telfer and the evolution of Wheaton and using the shares to acquire other projects and stuff. It seems like he wants to be a ďdeal junkie,Ē and I am not big on companies issuing a whole bunch of shares for mergers and acquisitions, because when they do the mergers, thereís a lot of stock that typically comes out. So I donít share the general enthusiasm for Yamana. The chart did break out, but itís been pretty heavy relative to the others over the last month or so. And basically just stay clear of South Africa.
TGR: A little power problem there. Multiple power problems.
IM: Power problems, tax problems, and royalty problems. Very few people made much of it, but having been to South Africa back in the í70s and having had long ties to it, it was extraordinary to me, absolutely amazing to see Anglo American sell off control of AngloGold Ashanti. They basically pieced it off by shifting their focus really toward iron ore in Australia. And boy, that says something about the South African gold mining industry. I suspect that Ernest and Harry Oppenheimer would be spinning in their graves.