Rick Rule: Systemic Shock Will Kill Sucker Rally
Source: The Gold Report (3/12/10)
Charismatic, articulate, contrary and persuasive, Rick Rule probably could draw an audience if he were talking about the weather. But combine his presence with knowledge, experience and a track record of success, particularly in the resource arena, and the crowd falls silent. Founder and chairman of Global Resource Investments, Rick recently made himself available for a brain-drain, and shared his insights on the direction of precious metals.
Lest you think the rallying stock market serves as a leading indicator that good times will soon roll again, along comes Rick Rule to rain on your parade. "The greatest bull market in history, beginning in 1982," he says, has trained people "to believe things will do well and get better"—training he considers lethal—and conditioned them to "buy the dips." Furthermore, he adds, "The amount of liquidity being injected into the system is truly spectacular. . .A lot of the stock market rally has been liquidity-driven." Interestingly, he notes, that liquidity is short term; while banks are still avoiding long loans that they can't resell to the federal government, Rick sees plenty of short-term money, lots of margin, ample lending to hedge funds, capital markets firms and individual investors.
He considers the markets "seriously overvalued," with the economy in no condition to support the capitalization rates, but expects the rally to continue on the basis of those two reasons plus the gradual thawing of bank credit for merger and acquisition activity.
Bottom line, though, Rick calls it "a bear market trap, a real sucker rally. . .driven by liquidity rather than valuation. And when the inevitable shock to liquidity hits—from additional foreclosures, a collapse in commercial real estate, implosion of municipal markets or wherever)—this bull market will be over in a tremendous hurry. He sees a variety of potential catalysts that could take this market down. There's no way of knowing when it will happen and how bad it will be, but he compares the likelihood of it happening to walking through a minefield. The odds are you'll step on a mine and it will explode. "This is a minefield that it would be helpful if you were extremely drunk to stagger through. I do not like the probability of us getting through this without a couple more ugly, ugly, ugly shocks. The idea that we're going to get through this unscathed just doesn't make any sense."
What could go wrong? Leveraged buyout loans in a weak economy. Additional reset loans in the residential market. Commercial real estate lending and commercial real estate capitalization rates. Municipal bond markets. Fundamentally, over the next 12 months Rick says, "I think we're due for extraordinary volatility—volatility with a downward bias in equities markets in general."
Make Volatility Your Ally
The extraordinary volatility he foresees in the equity markets might scare some investors away, but he argues, "Volatility's good if you use it as opposed to being used by it. It allows you to pick up assets on the cheap. I don't try to mitigate volatility. I think volatility is a tool. I try to enhance it. I have learned to react with absolute delight when a stock I think is worth a dollar falls to 50 cents. I buy the hell out of it at 50 cents. I seek to profit from volatility rather than to guard against it."
Rum to Treat Tequila Hangover
One big reason that Rick is waiting for another shock (or shocks) to the system is that he sees "the entire set of circumstances that led us into the crash 18 months ago is before us again. . .None of the underlying causes of the problem have been dealt with at all. We had a balance sheet problem; as a society we'd lived beyond our means and our liabilities exceeded our assets both in short and long term. As a society, we've decided to spend more and borrow more. We had too much collective debt, so we took debt from $2 trillion to $9 trillion. We've exacerbated the problem. It reminds me of a mathematical truism—you cannot add a column of negative numbers and get to a positive. That's not the way it works. This is the equivalent of us as a bunch of college students trying to cure a tequila hangover by switching to rum."
Speaking of mathematical truisms, Rick referred to the "cashless earnings" recently reported by a major financial institution. Though he's much smarter than the average bear, Rick confesses that he has "a very difficult time understanding the concept 'cashless earnings,' but the idea that people are excited about it from a bank whose assets are largely ephemeral and whose deposit liabilities people believe are real—that seems very, very problematic."
The idea of ephemeral assets leads to the topic of the U.S. dollar. Isn't its recent strength an encouraging sign? Rick repeats a wisecrack he hears (and makes): "The dollar is in fact the worse currency in the world except all the others." He also alludes to Doug Casey's description of the dollar: "IOU Nothing" (and the Euro "Who Owes You Nothing"). As Rick sees it, "currency crises in the last couple of years have always been kicked off by the dollar because people understand its counterfeit nature. For example, if one measure of value is scarcity, they've made the dollar substantially less scarce in the last 18 months by printing so many of them. But so has everyone else. The race to the bottom in the context of the debasement of currencies is a hotly competitive arena. . .the descent will be gradual but punctuated by air pockets. I can't tell you when we'll hit dollar or euro or yuan or peso air pockets, but I guarantee it won't be pleasant on the way down."
When it comes to the debate about whether the current environment is inflationary or deflationary, he thinks the coin falls in favor of inflation. "From a traditional economic viewpoint, you'd have to say the circumstances are deflationary. We are in the midst of a balance sheet recession. We have lived beyond our means and can't service our debts. The normal way to get out of that would be to stop consuming, start earning, paying down debt, defaults and foreclosures—that's clearly deflationary."
The Yield-to-Politician Factor
But ours is a political economy, he argues, and therefore "If you look at inflation-versus-deflation in yield-to-politician (which is what matters), you find a politician has no yield whatever from deflation. A politician who presides over foreclosures and unemployment will get kicked out of office."
Against this rather bleak backdrop, what does Rick foresee for the resources sector? "I think resources are going to be mixed," he says. "In the first instance, I do think we're going to have trouble in the broad stock market, and in the near term at least resource stocks are stocks. When liquidity is drawn out of the market, either intentionally or as a consequence of hitting an iceberg, there's no mercy. When speculators have to sell, they sell what they can, not necessarily what they want to."
Base Metals Jitters
More specifically, Rick anticipates broadly weaker base metal stocks going forward as a result of the weak economy. Accordingly, he's been reducing exposure to base metals ("although not in every case"). While he expects this market to hold up near term (up to six months) "simply because there's so much liquidity in the system and governments around the world are trying to perpetrate the fraud that everything is okay." But beyond that and looking out two to three years, he says, "I'm very nervous about base metals pricing." He attributes his jitters to such factors as anticipated demand—particularly from China—that may not materialize and the buildup of inventories. "I am coming to agree with the point of view that at least in the near term, China is involved in a bubble," he says, "and I'm very nervous about physical hoarding of base metals if there is disruption in credit. We have seen substantial restocking of base metals in the last 12 months by fabricators and speculators. There is nothing in the world like a credit contraction to spawn the removal of these inventories. So I don't have a good feeling about base metals prices in the near term."
Rare Earths: Too Much Ado?
He doesn't have a good feeling about the rare earths metals hullabaloo, either. Rick considers this "the latest of a fairly interesting, basically North American phenomenon" that he calls "sector rotation."
In a bull market, he explains, "where sectors get ahead of themselves, promoters make money dreaming up new stories, and stories in a sector where people haven't been burned before are the easiest to sell. Nobody had ever lost money in niobium or gallium or germanium because nobody could pronounce them or spell them" until these stories came out, he notes. "I think this is an enormous bubble that's going to crash. I have been delivering a lecture at some conferences about the real emerging minerals in this market—storium, fraudium, scamium, or for those who saw Avatar, my new favorite, unobtainium."
"Yes, this stuff can be used in cell phones (in miniscule amounts). Yes, lithium has some future in batteries." But the fact is, Rick says, the worldwide market for rare earth elements is about $2 billion. As he works out the math, it doesn't work. "If you assume a 30% margin (which I don't know is reasonable number)," he figures, "you are talking about $600 million in EBITDA. At a 10 times EBITDA number, you're talking about a $6 billion prospective market cap of that industry."
He cites another mystifying bit of math. "The largest lithium producer in the world is now down to 140 years' supply of lithium. The only reason they don't have a bigger supply is there's no particular sense spending money now to develop resources that you'll need in 150 years."
Insanity's Good for Gold
While reducing exposure to base metals and avoiding rare earths "like the plague," Rick says he feels good about the direction of precious metals prices and wants to increase his precious metals exposure. However, he says, he's "troubled by valuations that have limited my ability to rationally deploy capital."
As for the price of the king of metals itself, he expects it to go "broadly higher for classical gold bug reasons." Gold has served two functions through time—as a medium of exchange and as catastrophe insurance.
In terms of being a medium of exchange (money), he describes gold as "one of the few freely transferable assets that isn't someone else's liability. A dollar bill…has no independent utility other than as a medium of exchange; its value has to do with confidence. The root word of 'confidence' is con, and at some point, that con wears fairly thin. Gold is not an obligation to the person who gave it to you but an asset in and of itself. So I think gold will be increasingly valuable as a medium of wealth transferal."
In terms of gold's second function, as catastrophe insurance, he says, "People are going to be willing to pay higher premiums over the next five to 10 years. . .so the general direction of gold prices is higher."
That said, he reemphasizes his point that prices will go "broadly higher—but certainly not in a straight line." He expects "incredible volatility." To illustrate his point, Rick looks back to the period from 1970 to 1980, when the price shot from $35 to $850. "I remember very well when I cut my teeth in this business. In the midst of the greatest gold bull market in history, the gold price fell by 50%." Standing at $200 in late 1974, the gold price corrected all the way back to $100 before resuming its climb. History may repeat itself.
"People ask, 'How low could gold go?' It would surprise me (but not unduly) to see gold to fall from $1,150 to $700 or $750 in the midst of a general liquidity crunch, where interest rates tightened and as a consequence the U.S. dollar rose and the U.S. dollar-to-gold carry trade engaged in by so many hedge funds unwound."
If that were to happen, Rick supposes that "those neither psychologically nor financially prepared might get shaken out of gold positions in the middle of the greatest bull market we're likely to see for some time." He does not anticipate anything more than periodic pullbacks, but admits to very long odds on an extended decline. "I don't mean to be a cynic," he says, "but if the probability of catastrophe declined, the need for gold as a hedge against catastrophe would decline. That could be the case we decided to act rationally in the next five years and people lived within their means. It could be, but I see no evidence of that. I see evidence of people clinging to the Obama promise of hope. I don't think hope is a substitute for gold, so I don't see a case for an extended bear market in gold absent that economic sanity."
Again, however, Rick recollects an historic precedent from his early years in the business, when the gold bull of the '70s stopped dead in its tracks. "The gold price decline in the early '80s was really a function of a political consensus in the U.S. that said that speculative excesses and inflation were ruining the country." At the time, Federal Reserve chairman Paul Volcker was tasked with stifling inflation, which he tackled by sharply hiking short-term interest rates. "Volcker's decision to take interest rates up into the 20% range actually increased the value of the U.S. dollar, forced us to take some pretty ugly medicine and," Rick says, "reduced the need to hold gold."
Anatomy of a Gold Portfolio
Due to his sector experience, those who feel a need—or desire—to hold gold often ask Rick how to develop their portfolios. With the caveat that there is no one-size-fits-all answer "because it depends so much on the client," he says—not to overlook the elephant in the room—"I think a gold portfolio begins with gold. You need to consider either physical gold or the gold ETFs. I use the ETFs because my own portfolio is very long cash, and I consider gold very good cash. That is the way I personally would suggest using ETFs to the extent you're going to."
Rick also points out that constructing a balanced gold requires some representation of the majors. "They have this unique advantage over the juniors in that they have some gold. The good news about the majors is that after 10 years of rising gold prices, their operating margins are finally increasing. Last quarter was uniformly bullish for the majors, really for the first time in 10 years. Bad news about the majors is that they are fairly expensive and they're burning through their gold. They aren't replacing the ounces they produce. These are incredible liquidating gold producers. The idea that you should pay a spectacular premium to net asset value for a business that is declining in scope challenges the mathematical competence of the analysts who recommend them."
High-Quality Juniors: Hot-Ticket Tickers
The fact that the majors have lapsed when it comes to replenishing reserves and discovering new resources has paved the way for smart, resourceful, well-managed juniors to enjoy exponential growth and then get swallowed up by a major "at a substantial premium to what it is in fact worth on a net present value basis," Rick says. "We've seen M&A activity fairly strong in the last 18 months, and the next 24 months will dwarf what we've seen so far." For those reasons, he adds, he's "reasonably attracted" to a portfolio that contains "extremely high-quality juniors."
He puts the emphasis on that last phrase—"extremely high-quality."
"You'll need a competent broker to invest in the junior resources sector," says Paul van Eeden, a South African native known around the world for his expertise as a gold analyst, his work on the relationship between gold and currency markets and his insider's understanding of mineral exploration. Paul, who spent six years with Rick's company and spent considerable time evaluating resource companies, continues, "I use Global Resource Investments because they know how to trade these small, illiquid stocks and they also know more about minerals exploration than anyone else in the U.S."
Experience long ago taught Rick that "the juniors offer a different set of advantages and challenges" than their senior counterparts. In the first place, he says, "90% of the juniors that pollute public markets are absolutely nonviable and have no value whatsoever." As for the remaining 10%, "for those who have the courage and willingness to work, there's probably more value there than in the seniors. . .and so much money to be made by stock-picking."
Having said that, Rick cautions against counting on the predictions of pundits who have been calling for explosive growth in juniors. "As a sector, the juniors will never do what they did in the '70s," he says. "And understand the nature of punditry. Somebody who's trying to sell a newsletter can't have 'Steady as She Goes' headlines. The advisor has to promise tooth-fairy style profits in seven trading days."
Paper Trumps Gold
Another point he makes is that "paper always triumphs over gold. The only limit to the number of share certificates that Canadian juniors can issue is the standing inventory of timber between the Pacific and Atlantic oceans. They can print dreams on pieces of paper as fast as you can buy them. What happens is that as demand for juniors picks up, the volume of pulp reduced to share certificates and printed with lies and sold to investors can expand geometrically."
As Rick sees it, the only way to make money in this sector is by "pawing through the frauds to find the needles of value in this fraudulent haystack. Not an easy thing to do."
As part of that process, he explains, "Whenever I buy a stock, I have an absolute reason for buying it. I have an informal target, particularly with regards to the juniors. Value is added by the probability of answers to some questions. Before I buy the stock, I say, 'What is the question?' 'How does the management team propose to answer it?' 'Is that efficient?' 'Do they have enough money to do that?' 'What is the likely value of yes?' 'What is the probability of yes?' 'And how long will it take to get that yes?'"
Generally speaking, Rick says that he personally will not buy a junior stock absent "a reasonable possibility of an 18-month double and. . .that a succession of 'yes' answers couldn't give me a tenfold return."
Applying a similar philosophy in reverse, Rick says, "Knowing when to sell a stock really is a function of understanding why you bought it. For example, in the crash 18 months ago, I bought a couple of stocks selling at half cash. Because they didn't have much in the way of properties. . .they would be fairly valued when they were selling at cash. So when the market prices went from half cash to the price of the cash—when my expectation was met—I sold the stocks. I don't regard stocks as pieces of paper that trade. I regard them as fractional ownership of businesses, and when the price of that fractional ownership comes to reflect my value of the business, I'm a seller."
Expanding Cost Base
As a potential or actual fractional owner, Rick always pays close attention to company financials, and it certainly has not escaped his notice that while gold mining companies today are more profitable today than they were eight years ago, the tempo of the rise in earnings hasn't kept pace with that of the underlying metal (which soared from $250 to $1,100 between 2002 and 2010).
He suggests two reasons to explain the gap. "I believe they were high-grading deposits and not reconciling mine-grade with life-of-mine head grade, so they weren't reporting their earnings to reflect actual levels of depreciation and depletion. In and of itself, I think that was responsible for the rapid escalation of costs in the early part of the recovery of the gold price."
In addition, he's seen "a march of rising costs, and I suspect that will continue." He points to real cost inflation "throughout the value chain in the minerals business. Income taxes, payroll taxes, royalties—the government take from mining—have increased radically. As the mining industry recovered, its extraordinary demands caught service providers flat-footed in terms of capacity. So the world ran out of tires for open-pit mining trucks, among a whole host of other supplies and services. The steel price has gone up fourfold in the last 10 years, energy prices threefold."
His list goes on. "The prices of skilled workers have gone up substantially. I remember in the early '90s we had our pick of geologists and engineers to come to work for Global, and suddenly young geology grads from competent mining schools are getting snapped up. So labor costs are going up. What's escalated particularly for the juniors has been the compensation for managers, directors and administrators. It used to be that compensation in that sector largely took the form of a cheap stock position and options. The cash compensation and bonuses awarded by even micro-cap juniors now is mind-boggling compared to the level of compensation in the 1990—2002 timeframe."
Those Pesky Intangibles
And finally, Rick says, "the other thing that's really, really, really increased for mining companies around the world is the intangible cost of project development. . .a really understated component of the cost of mining." He's referring to evaluating and mitigating potential environmental and social impacts as well as navigating the long and arduous path to permitting—"all of the challenges that go into putting a mine into production."
Furthermore, he traces a significant portion of such costs to the fact that time is money. "To the extent you've engaged in successful exploration and gotten through the scoping study," he says, "from the time you feel a project is economic to the time you get in production lengthens. That increases the amortized cost of the exploration, because you have to pay interest on the money it cost you to discover that deposit for longer before the cash comes in."
Rick Rule, founder of Global Resource Investments, began his career in the securities business in 1974, and has been principally involved in natural resource security investments ever since. He is a leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture. Rule's company has built a national reputation for its specialist expertise in taking advantage of global opportunities in the oil and gas, mining, alternative energy, agriculture, forestry, and water industries.
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