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Frank Holmes: How to Avoid Vulnerability to Volatility
Source: Karen Roche of The Gold Report (6/7/10)
U.S. Global Investors CEO Frank Holmes, in this exclusive interview with The Gold Report, offers some sage advice about how to avoid vulnerability to the wild volatility that's come to characterize the markets and that delivers some of those devastating blows.
Frank Holmes: Yes, and deflation is the big factor to remember at the back of this. It's fighting deflation, and 80% of the time since the year 2000, interest rates on U.S. Treasury Bills have been less than the CPI number. That means a negative interest rate environment, and it means the government is trying to fight deflation; it's not really concerned about inflation. Gold will rise when you have temporary short deficits, but what we have is sustained long-term deficit spending while we're fighting deflation and negative interest rates. That makes gold extremely attractive against the U.S. currency. Although the dollar is not currently as anemic as it was, we've seen that in the U.S., and we're certainly seeing it in Europe, with what has taken place with Greece and the debasement of the euro. Interest rates in Europe have not risen either; they're basically negative.
Now, the last factor that is important in that triangle of factors that have a big impact is money supply. Gold hasn't gone to $2,000 yet, which a lot of gold fanatics had speculated because the growth in money supply has been anemic in the U.S., and in fact has contracted in Europe. The perfect storm where gold takes off is when money supply and deficit spending grow while real interest rates fall below zero—that is, when the rate of inflation exceeds the nominal interest rate. Gold will rise dramatically when those factors come together.
TGR: Over what timeframe should we be expecting this? Will it be gradual? Will it continue as it's been? Or should we see a rampant ramp-up on gold?
FH: I am not looking for a huge spike. I think it's going to defy the speculators, rising and falling back. What's really important will be the price-takers and price-makers. The price-takers—the jewelry buyers—have historically been the most significant factor. Every time gold has spiked about $100, price-takers stop buying, gold corrects and falls, and then immediately they come back in and start creating an underlying support.
Now the price-makers—that's the investment world—are coming in, seeing the currency debasement, seeing more people waking up it. These price-makers are basically owning gold, making a bet that it's going to trade higher. It's very important to remember that India took a position last October to become a price-maker, in addition to being the biggest price-taker in the world. They didn't want just dollars and euros and pounds sterling and Swiss francs as their reserve currencies. They want gold; they're diversifying.
This was very significant in 2005 when Russia decided to take 5% of foreign exchange revenue from oil and redeploy that back into gold as a reserve. Gold basically hasn't traded below $500 since then. What's taking place in India and many of the emerging countries, where deficit as a percentage of GDP and deficit per-capita is substantially less than in Europe or America, means that those governments are trying to diversify and protect their overall foreign exchange reserves. Gold is clearly becoming an important part of that, and I think that phenomenon will grow. As it does, we will see gold trade at higher prices.
TGR: With the price-makers exerting more influence, would the seasonal adjustments in gold go away? Should we expect new seasonal adjustments coming into place?
FH: I think we'll always have seasonal patterns, and they're very important in what they do as an overlay. I also think that we're dealing with a huge credit cycle bust. Smaller credit cycle busts usually take about five years to repair themselves. 1986 was the beginning of the S&L crisis, and it didn't bottom until '91. So if this major bust started in 2008—some say 2007—we still have another three or four years to go before we have some resolution.
But I expect waves of fear. Greece, for example. Then all of a sudden it's going to be Portugal. Both of these countries will have issues dealing with their huge debt bubbles that have been broken and policies from governments that are much more socialistic in their mindsets. It's very much like the '30s. That basically sets itself up for more protectionism, more unionism. I think this will be factor when people go to gold as a greater source of confidence. But that doesn't mean you go to buy gold to get rich overnight or the world's coming to an end. It's an ongoing volatile process of dealing with this credit contraction.
TGR: If the credit cycle bust repairs itself, will it also resolve—in some manner—many of the monetary issues we face today?
FH: Yes, I think we'll see some type of resolution in the next four to five years. Situations morph and do funny things, but if you go back to the '80s, it was Latin America that had all the debt crises. Many of those economies are very robust and strong today. In the '90s, Asia and Russia imploded, and their economies now are extremely strong on a relative basis of debt to leverage.
So now Europe and America are in these crises. I think we're going to go through this saga of change. Countries with free-market monetary policies are the ones buying gold. Those that are much more socialistic in their economic policies are the ones that advocate selling gold. I think we're going to see those dynamics unfold in different countries over the next several years. It's interesting that Gordon Brown is gone from power in England now, and he's the one who sold all the gold at $300. What would have happened if England had its gold today? The arrogance back then was the government would always be smarter than owning gold.
TGR: These days, of course, we're hearing about the credit and world reserve currency issues in the more advanced countries, whereas in the past it was Zimbabwe or somewhere else that didn't represent a significant portion of the global economy. Now that the "first world" countries are in trouble, many of the pundits are projecting catastrophes.
FH: I always like to see if the people who call for the most catastrophic events bet with their own money. Are they the biggest buyers of gold themselves? I am a gold investor, and I do have money in gold, and I do give it as gifts, etc., but I am not betting on a catastrophe. I am betting that things will get going again. Look at how Resolution Trust oversaw the workout of the S&L collapse of the late '80s and '90s. A lot of people lost money and lost their homes in that whole process, but many of them came out stronger and better, money came back in and bought those buildings, and things got going again. So, I believe what we have here is a super wave—it's bigger than was expected; it will bring lots of doubts and pain—but it will abate.
The problem has been in the mismanagement of leverage, and I really think it's important that you're not seeing it in mainstream media. You're not hearing all the debates. The media spotlight hits anyone who's made money. This just plays on the people's emotions. Policies will be well-intended, but they will be flawed because they don't deal with the underlying problem; the abuse of leverage.
For instance, all this new financial legislation being proposed doesn't do anything with Fannie Mae, which just came back for another $8.4 billion in bailout money last month. With leverage of 80:1, a 2% mistake in the portfolio is all it would have taken to wipe out Fannie Mae, but Fannie Mae goes on. Other examples: Merrill Lynch was 25:1. Lehman Brothers was leveraged over 30:1. When Japan peaked in 1989 and started its huge deflationary cycle, its banks were leveraged 30:1.
Really, the biggest problem is having financial institutions with excessive leverage. The odds are that they simply cannot manage it. But the rules coming out and the regulations being debated do not deal with that leverage; they deal with anyone who's made any money. There's confusion about the cause and effect of our problems.
TGR: Do you think the governments in Europe and the United States will actually identify the cause and address it?
FH: I don't know; I haven't seen it. It's not in the mainstream media. And it's not a political party issue; this is a thought process with both Republicans and Democrats who ignore Economics 101.
It's not so much the derivatives. Yes, we want them listed and we want better disclosure and transparency. But leverage remains the underlying issue. Most of the companies with big derivatives problems had very leveraged balance sheets. The real demonstrative factor is being leveraged 30:1 and then having derivatives on the books that are also leveraged.
Look at what took place in real estate. People were allowed—even encouraged—to buy homes with 100:1 leverage. Brokers ran around creating mortgage products leveraged 25:1. That tells me that we have to deal with the amount of downpayment. In China, people have to put at least 25% down if they want to buy a home, and most of the time it's 50% down. That makes a big difference. It doesn't stop the short-term volatility in housing prices, but it does stop the bankruptcies and foreclosures. When you have lots of that, the process of cleansing it in the marketplace takes five years.
TGR: Can we actually get to a resolution related to credit without addressing the leverage issue?
FH: I don't think so, but that's going to be later in the cycle. It's really just the beginning of the cycle, and we're going to go to Human Behavior 101—good intentions without really assessing the law of unexpected consequences that's unfolding in front of us. The pain and the difficulty for people that comes with managing the volatility.
TGR: How do people manage the volatility?
FH: It's so important to understand the 12-month volatility in the markets. For gold, over any 12 months for the past 10 years, plus or minus 15% is just normal. With gold stocks, it's plus or minus 40% over 12 months. Any day you look at your stocks, you could be down 40% for the past year or up 40% for the past year. That would just be one standard deviation. That would be normal.
Once you realize that, you know that you're at great risk if you're leveraged. But if you're not leveraged, you can turn around and use the down drafts to help you make more timely decisions. When you get huge runs—like when gold stocks climb 80% in a year—mathematically that's two standard deviations. When they go up that much in 12 months, there will be a correction.
It's just understanding that volatility.
TGR: How about with equities?
FH: The S&P 500 is more volatile than the gold. Over any 12-month period, I think the S&P is 17% and gold bullion is 15%, but gold stocks are much more volatile than the S&P—almost 3:1. That's the most important part. If you ignore that, you'll be buying at the top when gold is taking off because lots of negative news is breaking, but then it will correct, you'll be all upset and you'll be getting out of it and taking your losses. Use the volatility to your benefit.
TGR: So a prudent investor would wait to see if it's adjusting down 15% and start buying there. If it gets up too high, don't get too thrilled about it and buy more, but wait for it to come back down?
FH: Yes. You can usually expect mean reversion—that's the mathematical premise that all prices eventually move back toward the mean or average—even in a rising bull market or a declining long-term bear market. Each asset class has its own DNA of volatility. Basically, think of human relationships; some people are much more extroverted than others, and some are introverted. It‘s the same thing with asset classes.
TGR: And the junior gold stocks?
FH: They are so volatile that it's a non-event for them to go plus or minus 60%.
TGR: Plus the additional risks of going belly up?
FH: Not really. More technology and biotech companies go belly up than mining companies. Actually very few do. They get recycled, they get refinanced and they start all over again but seldom do they go bankrupt. I am not saying you can't lose a lot of money. You can lose 98% of your money on these puppies as they roll back their shares or refinance or go through that process, but bankruptcy doesn't seem to happen often in the gold space.
TGR: So, understanding the volatility and understanding the kind of fears that we'll face while we're resolving credit issues and leverage issues, suppose prudent investors want to get into gold as a hedge against inflation and deflation. What do they do?
FH: Buy gold on down days. If you're going to spend 5% of your assets in it, look for days when it falls about $35, then buy in 1%. Use that as a process to accumulate a position. Buy gold on sale.
TGR: That's physical gold. What about gold stocks, and juniors versus seniors knowing that juniors are more volatile?
FH: The psychology is that when gold rises above its 50-day moving average, money flows into gold. When it goes below its 50-day moving average, money flows out, and the juniors get spanked more. I think the reason for the 50-day benchmark is because Yahoo and Google have technical statistical default buttons set the 50-day and 200-day moving averages.
I was at a conference for CEOs recently, where they talked about some fascinating research showing that the investment public trusts—the word is "trusts"—the CEOs and brokers and money managers when a stock or fund they've invested in rises above their 200-day moving average. When it's falls below, they don't trust. It has nothing to do with the fact that everyone else is below and you're much outperforming; it's a psychology of people. You see money flows take place as a result of those ups and downs.
I'm looking at the psychology of the marketplace and how people make decisions, and trying to find reasons other than just emotionally buying at the top and selling at the bottom. It's tough, but it's useful to have something of a discipline. The easiest way to do that is to know what a particular asset's natural volatility is over any 12-month timeframe.
TGR: Is that trust linked to the 50-day moving average more driven by psychology or the fact that we've become more technical traders?
FH: Usually psychology. For instance, we see huge spikes, based on statistical models. We could back-test and show you those spikes. We could also show you spikes in bought deals and financings relative to what we call triangulation. Things are overbought; gold is way above its 50-day moving average, way above its normal volatility, news is very, very bearish, and lots of financings are knocking on the door. That's usually the worst time. That's usually correction time. We always ask ourselves if we've got triangulation going on there. We don't want strangulation.
TGR: Everybody's always asking you about gold. But you're a big fan of natural resources broadly speaking, buying into this commodities supercycle. From where you sit, are your interviewers missing the bigger investment story by concentrating on gold?
FH: Yes, I think it's much broader than gold. A super socioeconomic shift is going on. The thesis is that in 1970 China and India represented basically 1% of global GDP. Now they're 10%, but they contain 38% of the world's population. Their GDPs are growing at three times the rate of Europe or America. Okay, 38% of the world's population is a lot, you might say, but only one-tenth of the world's GDP? But some really important factors are different than in 1970.
TGR: Such as?
FH: China and India get along with each other. They both have the Internet now. They both are economic engines and looking for trade. They're both seeing the rise of the middle class as in the movie Slumdog Millionaire. In China, 300 million people speak English; more people are speaking English in China today than they do in the U.S. America. And India is pushing further along that path. Every child now has to have an education—it's the law there now. So they'll be building new schools, new systems, new hospitals. The shift of populations to urban centers is creating greater demand for resources, services and infrastructure as well. The estimated needs for infrastructure spending are staggering—trillions of dollars across the world to develop water, energy, transportation and telecommunication networks. That infrastructure building needs copper, needs cement.
So now you have this supercycle infrastructure spending, along with the cultural affinity toward gold as gifts and increasing appreciation of gold as a monetary asset in these countries. That creates backup demand for gold as well as backup demand for all the other commodities to build up their infrastructure.
TGR: A lot has been written about China investing in commodity companies, stockpiling commodities, converting their U.S. dollar reserves into commodities. Is there still a commodity play for China?
FH: Yes, there's no doubt. They're trying to manage runaway price increases because they believe it causes social instability. What's really important to understand is it's a two-pronged model for China—social stability and a means for people to make money. They're very conscientious in fine-tuning social stability and job creation year after year. Infrastructure spending is the most important for long-term job creation; but at the same time, people get upset if food prices spike or they can't afford to buy a house. So the government tries to come up with policies to maintain the balance. I think they're very proactive. They're not naive. The Communist Party wants to stay in power, and the only way to do so is to ensure social stability and a means for people to get jobs.
TGR: Does this drive just the commodity supercycle? It seems that it would also trigger a technology boom, a transportation boom, a consumer boom.
FH: They're all coming. The significant consumer impact comes later in the cycle. Consumption as a percentage of GDP is much higher in India than China. China's fixed assets are higher, but I think we can expect to see the fixed assets explode in India. But it's not a linear process, not a straight line. It's bound to be fraught with lots of volatility and excitement and opportunities to make money (and lose money).
TGR: What are some of the commodities your fund is focusing in on as you look at the supercycle?
FH: Copper is a great precursor for industrial production, from making appliances and air conditioners to putting up electrical units across the country. Net coal is important; iron ore for the consumption of steel; zinc coated for the cars they're making. They're interrelated, and one has to track them and look at supply and demand factors and then look at the government's policies. We're big believers that government policies are precursors to change, both domestically and internationally.
TGR: In terms of copper, net coal, iron ore and zinc, is there a way an individual investor can play those commodities?
FH: The cleanest way is to invest with an active money manager—and not the ETFs. If you buy stock ETFs—equities, not the bullion ETFs or commodity ETFs—and they go up on a big day, they trade at a premium to NAV. If you sell on a down day, they trade at a discount. Trading equity ETFs can end up costing you a lot more money than a mutual fund with a good active manager who understands rotations that take place in the different commodities and how they relate to the equities.
Gold Report readers should just be aware that the leverage for every 1% move in a commodity usually translates into a 2% to 3% move in the underlying companies. The volatility is much greater for the equity than for the commodity itself—both on the upside and the downside.
TGR: And as you said, you pay an invisible markup when buying an ETF on the upside, and on the downside, it sells at a substantial discount.
FH: Yes, depending on when the transactions are made. It can add up, too. These premiums and discounts can be wide, especially on days with big NAV changes, and the premiums/discounts can swing very quickly from one extreme to another. We've seen 6% swings in a matter of a week, and I think we saw a 14% swing over two weeks in the Russia ETF, with people buying in on a big up day and selling on a big down day. You can track where the money flows are the biggest. They left a lot of money on the table. So, I think there are associated risks with those ETFs.
TGR: Are some countries today undervalued based on the government policies that have changed or enacted recently?
FH: I think when a country looks as if it's undervalued, there's usually an election going on. So one has to turn around and ask why that country is underperforming all of a sudden, and one has to go look at the election trend and see what the leadership is—or is just uncertainty that's the trigger? You may laugh, but I think that Greece may have some great opportunities because in percentage terms some of those public companies have fallen dramatically, way below their fundamental valuations. Baron Rothschild always said to make big money, "you buy when there's blood in the streets"—as there is now in Greece. That's a classic of when things are down, in percentage terms, on the most extreme levels.
TGR: Speaking of elections, do you see some opportunities in Colombia?
FH: How will things fan out after the May 31 elections? Will the policymakers favor economic activity? We don't know yet. The best performing stock on the Colombian Stock Exchange last year was Pacific Rubiales Energy Corp. (TSX: PRE; BVC:PREC), a Canadian company listed in Colombia and producing oil in Colombia.
I think being early in those countries, which we were, is a benefit because we were able to identify great government policy and get behind wonderful entrepreneurs with a great track record. They've been through the ups and downs before and that's truly important when navigating these markets. You just don't go into a country for the sake of a country; you have to make sure what the policies are for job creation and social stability. You also have to make sure that the CEOs and directors of the companies that you're investing in know how to navigate through the culture, the legal environment and the politics of that particular country.
TGR: Only 15 years ago, risks were such that you needed armed guards just to visit Colombia.
FH: Today that's Mexico. It rotates. We go from a free market to a socialistic, back to a free market. It just rotates. The job of an active money manager is to be able to see that rotation and move quickly with it.
TGR: Any last thoughts for our readers today?
FH: I think it's really important for people to understand peaks and valleys in life. It's almost like a philosophy to understand that we all have them. The peaks are not just at the good and bad times that happen to us; they're also how we feel inside and how we respond to outside events. How we feel depends largely on how we view our situation. I believe the key is to separate what happens to you from how good and valuable you are as a person. If you don't, all of a sudden you end up buying at the top and selling at the bottom when you see a big correction. You start to feel terrible about yourself, which affects your sense of self-worth as well as your net worth. It affects everything in your life.
Your beliefs and values shape your actions. I try to tell people to know the volatility so they can manage and understand these factors better and make better decisions. I want to help them avoid becoming a victim to the ebb and flow of the tides, but rather help maneuver their ship easily in and out of the harbor.
Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc. (NASDAQ:GROW), a registered investment adviser with approximately $2.7 billion in assets under management and a year-over-year increase of 400% in per-share earnings for the quarter ended March 31, 2010. The company's 13 no-load mutual funds, which offer a variety of investment options, have won more than two dozen Lipper Fund Awards and certificates over the last 10 years. Its World Precious Minerals Fund was the top-performing gold fund in the U.S. in 2009— the second time in four years it achieved this distinction. Frank has been U.S. Global Investors' CEO since purchasing a controlling interest in the company in 1989. He co-authored The Goldwatcher: Demystifying Gold Investing, which was published in 2008. A regular contributor to a number of investor-education websites and speaker at investment conferences around the world, he maintains an investment blog called Frank Talk, writes articles for investment-focused publications and appears as a commentator on business channels such as CNBC, Reuters Television, Bloomberg Television, Fox Business Channel and CNN's Your Money. Frank, who has been profiled in Barron's, Fortune, the Financial Times and other publications, was named Mining Fund Manager of the Year by The Mining Journal, a London-based publication for the global natural resources industry, in 2006. The World Affairs Council's chapter in San Antonio, Texas—home base for U.S. Global—named him 2009 International Citizen of the Year. In addition to achievements as an investor in international markets, the award recognized Frank's involvement with the William J. Clinton Foundation to provide sustainable development in emerging nations and with the International Crisis Group to avoid and resolve armed conflicts around the world.
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1) Gold Report publisher Karen Roche personally and/or her family own no shares of companies mentioned in this interview.
2) The following companies mentioned in the interview are sponsors of The Gold Report: none.
3) Frank Holmes: I personally and/or my family own shares of the following companies mentioned in this interview: none