James Turk: Gold – The Ultimate Inflation and Catastrophe Hedge
Source: The Gold Report (5/20/08)
James Turk, a renowned authority on gold and the precious metal markets, says "take a long-term view and steadily accumulate gold month in and month out," in Part I of this Gold Report interview.
TGR: You're a big proponent of owning gold. Do you think that's the best course given the current state of the economy?
JT: Yes, for two reasons. Gold is an inflation hedge because it preserves its purchasing power over long periods of time by keeping up with inflation, and inflation is a growing problem. But gold is also a catastrophe hedge, because it is money that doesn’t have counter-party risk. In other words, you’re not reliant upon someone else’s promises for the value of that wealth, which is becoming increasingly important given the perilous state of the banking system and growing possibility of a financial meltdown. But don’t try trading gold. Accumulate it. You really should take a long-term view and steadily accumulate gold month in and month out. In other words, dollar-cost average your purchases. Sometimes you might buy at a higher price, but sometimes you’ll be buying at a bargain, which I think describes the present situation. We’ve been in this set of circumstances many, many times before over the past eight years, but obviously at lower prices. The market runs up to a level and ends up getting hit. The speculative element comes in near the top; they then get forced out, as the market reverses and goes through a correction. But if you have a steady program of accumulation, sometimes you might be buying at a higher price, sometimes you might be buying at a lower price, but the key is that you’re riding with the major trend, and the major trend is still up. And the reason why the major trend is still up is because of all the monetary and financial problems that we’re confronting.
TGR: What do you see is causing the downward pressure on gold after breaking through the mythical $1,000 mark?
JT: I think there are a couple of factors. I think number one on the list is the gold cartel. They’re still trying to keep gold capped in order to make the dollar look worthy of being the world’s currency, when, in fact, we all know the dollar is not. Gold is the barometer that tells whether central banks are doing a good job or not in managing the currency. And by keeping gold lower than it otherwise would be, it makes the dollar look better relative to its major competitor, which is, of course, gold.
Another factor is speculation. There are really two gold markets. There’s the physical gold market where bullion trades—the actual physical metal. Then you have the paper gold market—futures, options, and that type of thing—where you get a lot of speculation. And from time to time, the paper market can drive the physical market, but ultimately, it’s the physical market that determines whether gold is in a major bull market or not. The paper market can drive the short-term swings, both on the up side and the down side, like we’ve seen over the past couple of months.
But the physical market drives the long-term market because it’s physical gold that provides those two benefits of gold; that is, it’s an inflation hedge, and it’s a catastrophe hedge. Those benefits come to you when you own physical metal. They don’t come to you when you’re trading in a leveraged way in a futures market because on the futures market, you don’t own gold; you only own exposure to the gold price.
TGR: What about the seasonality? Typically we have seen summer doldrums where we’ve seen a rise in the gold price. How do you see it playing out this year?
JT: Yes, seasonality generally works about 75% or 80% of the time, believe it or not. You normally have a strong period in the fourth and first quarters. After a first quarter peak, you typically start declining in the second quarter, and then in the third quarter you go sideways and consolidate, and then you go higher again.
But having said that, 75% of the time is not 100% of the time. So, seasonality is important except when it doesn’t work. And it’s been my view that this is a year when seasonality is not going to be important, although so far it has played the pretty typical seasonal pattern, with the peak of the year so far, in March. And it looks like we might be heading into the summer doldrums, which, again, is typical, but there are years when the seasonal patterns don’t work. And my view is that the seasonal pattern isn’t going to work this year because I’ve viewed this year to be very similar to 1974, which was the last major financial and monetary crisis in this country. In 1974, things just kept getting worse; when one financial crisis was done, another one would pop up.
The financial problems culminated in August of 1974 with the collapse of Franklin National Bank in New York, which was up until that time the largest bank failure in U.S. history. But the stock market continued to swoon until forming a double-bottom in December that year. And the gold price rose 73% throughout it all that year, so seasonal patterns didn’t matter in 1974. And given all the financial and monetary problems we have already experienced, and given the fact that I don’t think we’re anywhere close to the end of the dark tunnel of financial and monetary problems, my view has been that seasonal patterns in gold aren’t going to be important this year.
TGR: Like Richard Russell says, “It’s not about what the price of gold is; it’s how many ounces you have.”
JT: Exactly, and that explains what’s really happening. It is not that the price of gold is going up, it’s that the purchasing power of the dollar is going down. I like to explain this is by using a chart that looks at the price of crude oil in terms of dollars and also in terms of goldgrams. And basically, the price of crude oil over the past 60 years has risen dramatically when viewed in dollars, but it’s essentially unchanged when you look at it in terms of gold. When you look at it in terms of dollars, it’s 110 times more expensive than what it was 60 years ago. That’s because the dollar has lost about 90% of its purchasing power since 1974, and 97% since 1945. The point is that the dollar is losing purchasing power because it’s being inflated away—too many dollars are being created, and that’s the problem of all fiat currency. Fiat currency is not backed by anything but government promises. Consequently, there’s no discipline in the money creation process. Monetary history has shown that wherever there’s no discipline in the creation of money, it’s always created to excess. And when it’s created to excess, that ultimately destroys the currency because of inflation
TGR: What’s your take on the junior gold stocks or the gold stocks in general? There seems to be a disconnect. Do you see that ETFs may have taken away some of the buying power that would otherwise go into the gold stocks themselves?
JT: Well, I am not a big believer in that for the reason that stocks are one thing and bullion is something else. Stocks are an investment, and you have the risks that you normally find in investments—the management, the balance sheet, the political risks, and so on. But, bullion is money. It’s not an investment, as I was saying as an example with crude oil—an ounce of gold buys nearly the same amount of crude oil in did 60 years ago. So, that’s a pretty lousy investment because it hasn’t generated any return.
But gold is wonderful money because it’s very useful in communicating prices over long periods of time and preserving purchasing power – you still get the same amount of crude oil for one ounce of gold. So I do not believe the ETFs have taken away a lot of the buying from the mining stocks.
Let me divide stocks into two different categories to make sure we’ve got the definitions right. First you have the large and small producers—those that are actually mining gold. And on the other side you have the non-producers. These are the development companies that are bringing a deposit into production, and then you have the property plays, which are exploring for new deposits.
The producers have had some very, very strong headwinds over the past couple of years. They’ve had energy prices going up more rapidly than the gold price. Although it’s still within that historical 60-year band, we’re at the upper end of that band, which basically says that energy is high and gold is relatively cheap. What it means though, is that the margins of the mining companies have been earning with these high energy costs is smaller than it would otherwise be if gold was high relative to energy costs.
But inflation has also hurt companies in a number of other ways—the cost of steel, the cost of chemicals, and the cost of labor. Everything is going up. The reality is that the inflation rate of producing gold has gone up much, much higher than the government-reported inflation rates. And I think a lot of gold mining companies have been operating with inflation rates of 12% to 15% over the past couple of years, perhaps even higher in weak currency countries like the United States, as weak currency countries tend to have a higher inflation rate. But we’re even seeing the pressures on mining company margins in strong currency countries like Canada, because the gold price has not risen as much in Canadian dollar terms percentage-wise as it has in the U.S. dollar percentage-wise. So Canadian companies have felt the pressures on margins, too.
The reality is that the margin pressures on the major gold-mining companies are continuing, and until the gold price starts to begin rising at a rate outstripping the inflation rate, you’re going to continue to see these margin pressures. Now, because the margin pressures have hurt the producing gold companies, both the large producers and the small ones, they’ve underperformed, and that underperformance has taken a lot of the luster out of the whole mining sector.
And when the luster is taken out of the whole mining sector, the property plays and the development companies are also going to be impacted and underperform. But the development companies have also had another problem besides inflation, namely, start-up problems. We’ve had good examples of this with Gammon Gold and Alamos Gold in Mexico—their stocks have been hit because of start-up problems. Then, you had NovaGold—its joint venture partner decided not to construct the Galore Creek Mine simply because costs have risen so much.
All of these things have cumulatively hit the non-producing companies, and then at the end of food chain, of course, are the more speculative property plays. Give the overall state of gold stocks, the property plays are going to be hurt the most because there’s really very little liquidity there when little money is coming into the sector. And when people have to sell—because a lot of these things are played on margin— the prices of the property play stocks get decimated.
TGR: Without going into specific names, how would you invest in the mining stocks? Would they be a mixture of producers, property plays, or are they only producers?
JT: My view has been that one should have 80% or more of a portfolio in the producers, and 20% in the near producers or property plays because they don’t generate cash flow, and cash flow is obviously important. That’s the sort of the mix of risks that I like. There are of course risks in the producers just as there are in the property plays, but the risks are different and this mix just suits my temperament.
Generally speaking—and I’ve been recommending the accumulation of a variety of gold stocks since October 2000 when I started turning bullish on them— a lot of them have done very well over that period of time, but as expected, a couple of them have been underperforming too. That’s one reason why I recommend a diversified portfolio, as it is impossible to pick only winners, and the losers get balanced out in a diversified portfolio.
As the price of gold goes up, there will be appreciation in the price of stocks, too. But for me, the critical measure is the price of mining stocks relative to gold itself, and for this, I like to use the XAU Index. I calculate how much it costs to buy the XAU with grams of gold, and you get an oscillator that really shows whether the gold stocks are overvalued or undervalued relative to the gold price, which obviously is the price of the product that they produce.
The relationship is that if it costs 10 or more goldgrams to purchase the XAU Index, the mining stocks are relatively overvalued, and gold is relatively undervalued. In which case, you should be moving out of the stocks and moving back into bullion itself.
On the other hand, when you’re down to six goldgrams to purchase the XAU Mining Index, the stocks are very undervalued relative to gold itself. We are in a situation again where we’re down around six goldgrams to purchase the XAU. We were back at this level at early 2001, which is back before the gold stocks started moving. We were back at that level again in 2005 before the gold stocks made another big move. So to me it suggests that the mining stocks are undervalued relative to gold, and you should be maximizing your position in the mining stocks at the moment because they are cheap and a big move up is likely based on past experience.
But again, keep in mind that mining stocks are an investment, gold is money, and you can’t really make a direct comparison between the two in terms of performance results. But if you want to reduce your liquidity and reduce your money holdings, then mining stocks are definitely the place to be again. Based on historical experience, they are cheap relative to gold bullion.
TGR: What percent would you recommend that an investor have in bullion and what percent in mining stocks or the XAU?
JT: Well, again, it’s hard to make sweeping generalizations that fit everyone’s circumstances, but I’ll make a couple anyway. The first is that you don’t want to have dollar-denominated assets. In other words, you don’t want to have assets which when they mature or come due are only going to pay dollars back to you. So, you don’t want to have T-Bills; you don’t want to have dollar-denominated bonds, whether government bonds or corporate bonds. You don’t want to have dollar-denominated bank accounts. That’s because the dollar is on this downward path; what I call the path to the fiat currency graveyard. And unless it gets off this path, and sooner or later, the dollar is going to get there. I think it’s going to there sooner rather than later, given the mismanagement of the dollar that we’re seeing today and how weak the dollar is relative to other currencies of the world, as well as commodities and other tangible assets.
So, that’s the first point. Secondly, you should have, in my view, a relatively high liquidity in your portfolio at the moment. One of the measures that I look at is how expensive the Dow Jones is in terms of gold, and historically, when it’s 30 or more ounces to buy the Dow, the Dow is overvalued. When it’s one ounce of gold to buy the Dow, the Dow is undervalued, in which case, you sell your gold and you buy the Dow.
Back in 2000, it was 43 ounces of gold to buy the Dow; we’re now at about 15 to 16 ounces to buy the Dow, so the Dow is still relatively expensive compared to gold. So, my general recommendation is that you really should not own a lot of stocks at the moment, other than resource and tangible asset stocks, which I will explain in a second. And you should be sitting more in cash—but not dollar cash—you should be holding gold cash, waiting for the Dow Jones comes back to a level that represents good undervaluation on the Dow and overvaluation on gold, which is when 1 ounce of gold again buys the Dow Jones Industrials.
So the second point is that there should be a relatively high liquidity position in one’s portfolio, and, again, it depends on what every individual subjectively feels comfortable with, but I think that the liquidity position—gold and/or silver—should probably be a third of one’s portfolio — or perhaps even as much as 50% of one’s portfolio.
The third component—to answer that question—is what should be invested in stocks. If you are going to own stocks now, you want stocks that are involved with tangible assets—energy companies, natural resource companies, mining companies. Those stocks have done well for a few years, and I think we’re still early in this cycle, so I expect that those stocks will continue to do well. When you look at a mining stock, regardless of whether it’s located in Canada, South Africa, United States, or wherever, look at the stock itself because the value of the company lies in the fact that it’s producing gold. It has to deal, of course, with the currency where it is operating because its expenses are basically in that currency. But essentially, in a rising gold price environment, those expenses should become less and less over time. That’s the basic theory why you want to own mining stocks in this kind of an environment.
TGR: You mentioned silver. Where does silver fit vis-à-vis this overall portfolio vis-à-vis gold? Certain newsletter writers and advisors have been thinking that silver needs to catch up with gold. Tell us a little bit about that.
JT: Looking at it from the long-term point of view first—silver is money, too, just like gold. And silver can do the same thing that gold does—it’s an inflation hedge and a catastrophe hedge. But silver is more volatile than gold; so the way I describe it is if owning gold is like flying in a 747, then owning silver is like flying in an F-15. Both of them will get you there, but the ride on that F-15 is going to be pretty volatile, with lots of zigs and zags and some heart-stopping reversals like the one we have just seen when silver soared to $20 and then reversed to $16 in a matter of weeks.
But in order to make a decision on gold and silver, if you can stomach the volatility, silver is actually a better value than gold, and here’s the logic behind it. The geologists who understand this tell me that there is 10 times more silver in the earth’s crust than gold, so logically, one would think that the silver-gold ratio should be 10 ounces of silver per one ounce of gold. But that’s not the case; historically, the relationship has been about 15-to-1, which is what it was in January 1980 when the last precious metals bull market peaked. And then during the 1980s and early 1990s it went the other way; the ratio went to over 100 ounces of silver to buy one ounce of gold in the early 1990s.
And now, we’ve seen the ratio coming back again; we’re at about 52 ounces of silver to buy one ounce of gold. So given this 10-to-1 ratio of silver in the earth’s crust and about the same ratio of silver to gold being mined each year, the ratio of their prices is clearly not just a question of supply, it’s also a function of demand, and the demand for gold is very inelastic. In other words, people hold it regardless of what happens to the price. For silver, on the other hand, the demand is very elastic, which means it’s very sensitive to changes in price.
So, what happens is when money exits the precious metals, like it did in the 1980s, it has a bigger impact on silver than it does on gold. Consequently, the gold-silver ratio rises. When money comes into the precious metals, as it’s been doing since the mid-1990s and particularly this decade, again it has a bigger impact on silver than gold, so the ratio falls. Given the fact that historically it’s around 15-to-1, and we’re at 52-to-1, silver is relatively good value compared to gold itself. So, even though gold is cheap, silver is even cheaper, and given the fact that both silver and gold are both an inflation hedge and a catastrophe hedge, silver would be the preferred asset to hold if you can stomach the volatility.
TGR: Going back to having real bullion, if you will, or the one-third to 50% of your portfolio, how would you have that blend between gold and silver?
JT: As a rule of thumb, you should probably have one-quarter silver and three-quarters gold; again, just because of the volatility issues. That I have found historically to be a comfortable level for me. But I know some friends that are the other way around; they have three-quarters silver and one-quarter gold.
TGR: And avoiding the dollar as your ultimate currency, what currency would you suggest at this point for a three- to five-year timeline?
JT: I think you should hold your liquidity in gold or silver or rather than any currency. When you need a currency to travel to Europe or to travel to Argentina or to buy groceries in the country where you live, every month sell some of your gold or silver, put it in that currency that you need, and then spend that currency. Then, the next month, do the same thing. And the reason why I say this is that while the problems of the U.S. dollar are huge, they are not unique. All of the currencies of the world today are fiat currencies. They are all backed by nothing more than government promises, and all the currencies are inflating. They’re just inflating at different rates. And the important point to recognize is that gold are silver are rising in terms of all the currencies of the world, so you’re better off holding the precious metals, because by holding them, the appreciation in the metals is even better than holding a currency and earning interest on that currency. It’s particularly clear in dollars. Gold has appreciated 17% per annum over the last seven years, on average. And while gold’s appreciation hasn’t been as high as against other currencies, it has been in double-digits in most of them.
TGR: You’re saying you want to have your assets in real money, which is gold and silver.
JT: Yes, you want to have your money – that portion of your wealth held as liquidity – in gold and silver.
GR: Where do you think gold and silver will be at the end of this year?
JT: Well, I am not changing my price forecast. Back in December I said that we’re going to see a four-digit gold price this year, and we have. I am expecting gold will go up to $1,500 sometime during the course of the year and my year-end target is $1,100 to $1,200. I’m sticking to that same forecast. And in silver, I think we have the potential to go in the ratio from the 50s down to 40 or 42. And a 40 ratio at $1,100 to $1,200 that puts silver around $28, maybe $30.
TGR: Where did the $1,500 forecast for gold come from?
JT: Gold is being driven by safe haven buyers—people who want to exit financial assets and not have to worry about some financial company or bank or some financial problem blowing up and putting a hole in their portfolio.
TGR: Do you have a comment on interest rates? What do you think the Fed is going to do, looking out to '09?
JT: Well, the important thing to note is that Ben Bernanke is doing the exact opposite of what Paul Volcker did. The circumstances are similar—back in the 1970s and 1980s and where we are today. Inflation is becoming a severe problem; the value of the dollar relative to other world currencies and commodities is falling. And what Volcker did in order to convince the world that the dollar was going to maintain its value is that he kept raising interest rates. This is standard central bank policy. When there is a question about the value of the currency, you keep raising interest rates, and it’s going to cause an economic contraction as it did in the early 1980s, but everybody eventually understood that the dollar was not going to be destroyed as currency. The precious metals peaked out, and people went back into financial assets.
This time around, Bernanke is doing the exact opposite; he’s lowering interesting rates, making it even more unattractive to hold dollars. Right now, based on the government’s reported inflation, the real interest rates—in other words, adjusting them for inflation—are a negative 2%. So for example, if you today have a $100 in purchasing power and you deposit that money in a bank to earn interest, at the end of the year you have $98 in purchasing power, inflation adjusted. And that’s by the government’s own calculations of inflation, which I think significantly understate the true inflation rate. I think negative interest rates at the moment—real interest rates—are probably closer to minus 8% to minus 10%. In that environment, there is no reason to hold the dollar, and that’s part of the reason why the dollar has been collapsing against foreign currencies and tangible assets.
So, it’s a question of what the focus of the central bank is going to be. Volcker took the traditional central banker’s stance, raised interest rates in order to save the currency. Bernanke has gone off a new tangent; he’s lowering interest rates in order to save the economy, and the currency is being destroyed. But if you destroy the currency, you’re never going to save the economy either. Eventually both will end up being destroyed. So I think there’s been some bad decisions being made by the Fed by lowering interest rates. They’ve changed the focus from where it should be. They’re focused on trying to save the economy and the big banks, rather than trying to save the dollar, which is where they should be focusing.
TGR: And you don’t think he’s going to change his course?
JT: I haven’t seen any signs of it. The Fed talks about tough anti-inflation policy, but on the other hand, they’re out there easing. And all you have to do is look at interest rates adjusted for inflation. They haven’t been this low since the late 1970s, the last major dollar crisis and when the price of gold was soaring. They’re going to have to raise interest rates. I don’t know when or what the exact level will be. But if they’re going to convince the market they’re going to save the dollar and prevent its collapse, they’re going to have to raise interest rates. Or they’re going to have to try something else to prevent a dollar collapse. My view has been that the government will impose capital controls to prevent people from doing what they want with their money. So, for example, Americans may not be able send money abroad or take a trip to London unless you get the central bank approving the foreign exchange purchase. And clearly we don’t want to go down that road because that just further restricts our ability to act freely and do what we choose with our money.