Must Read: Debt Crisis Ignition

Source:

"Markets are factoring in growth based on wrong assumptions."

Introduction

Isn't that funny; everybody is getting risk adverse again—what a surprise. Before I highlight an excellent strategy for U.S. and European investors I need to announce two general warnings about the near future. Markets are currently irrational and dangerous because they have factored in growth based on wrong assumptions. This has recently led to the wrong stance on risk in the global markets as well. We have been warning our Members about this and related issues for a few weeks in our newsletter—ahead of the recent high so they had the opportunity of selling into the strength.

Earlier in the year I called for a buying season for the Australian gold stocks in May and June and it was a good call. Sixteen of our stronger gold producers made lows in that time frame and then went on to rally however like elsewhere else the rally has been lacklustre. The emerging gold stocks did better on average than the larger stocks on an unweighted basis. Volume is not there because liquidity has been drying up it is as simple as that. There is an increasing probability that offshore buyers from Europe and the U.S. will get an even better opportunity here than the May to June period. All of my research points to the likely probability of a really exciting investment opportunity in the coming weeks. More importantly this could be a key opportunity to get some investment funds to safety out of the U.S., the UK and Europe.

Conditions in the U.S., Europe and the UK are clearly deteriorating however I would not advocate a move into the Australian gold stocks just yet. Yes the mid to smaller end of this sector is extremely good value right now, just as it was in August 2008 and you saw what happened that time as liquidity dried up.

Investment Overview

Extrapolating the next ten years based on the past ten years, or if you like measuring backwards to assess relative future investment returns is like driving a car down the road using only the rear vision mirror. I literally saw a school bus driver do this last week as he pulled out onto a state highway with near disastrous consequences. In this investment climate you are going to find yourself off the road in no time with this investment philosophy or head on into a bus. Conditions are different now.

It still amazes me to see main stream press talking about average 10% property returns over the past ten years and ASSUMING this is possible over the coming decade. It takes a big picture understanding of long cycles, debt markets and monetary history to have any idea what we face in the next ten years and even then we are only taking an educated guess. Having a big picture view and an open mind will at least save you from that bus. Any basic understanding of economics 101 should alert you to the fact that we are facing a significantly more challenging investment climate than we have at minimum in the past 80 years.

The Australian print media seems largely unaware about this and even worse they cannot seem to see offshore far enough to understand that the Australian economy is a part of the global system. Given that we are reliant on global debt markets and economic growth constraints like everybody else I have to wonder about the waste of black ink and paper when I read some of their misinformed missives. The looming devastation effect on many Australian families is the worst aspect of this travesty.

The first warning is therefore—don't believe what you are reading about property investment in Australia or any investments for that matter at present. The second warning is related to the near term future due to changes in the Financial Regulations Bill in the U.S. and conditions in the debt markets. There is no epicentre to this disaster however the common thread is excessive debt levels. The problem exists in at least 32 states of the USA, the UK, most of Europe and Japan just no name the main problem areas.

We have been saying that the global economy, gold and equities will soon enter another crisis phase similar to GFC1 due to a lack of liquidity. Each asset class will react differently as this unfolds further. There is some talk around the market on aspects of the changes in the bond markets however not many investors have picked up this and understood the ramifications. We did and we have been telling our Members quietly for a number of weeks.

Emergency Newsletter

On July 26th I released an Emergency Newsletter that explained some new events that have still not rippled through the system as yet. We were discussing the implications of the recent Financial Regulations Bill and had this to say:

"As one other experienced market participant put it—"It's still kind of murky, I've been involved in the asset-backed markets for 18 years, and I don't understand [the legislation] at this point. If I don't understand it, a lot of people don't."

Editor's comment: Well if he doesn't understand this then what hope do the equity investors have. Debt is a foreign area to them so they will not see the effects of this coming either. The European stress tests exposed a clearer picture on the EMU banking system debt necessitating a reassessment of risk in the region. This exacerbates this effect."

Since GFC1 regulators have bought time for some institutions to make major balance sheet improvements and have tried valiantly under extremely difficult circumstances. One problem is that no matter how much banks were supported they have been playing the yield curve rather than investing in business. Tying up their capital in Treasuries does not help small to medium enterprises or the economy so growth and employment have been poor.

To help you to understand this situation I have to use a four letter word, one we all hate: debt. The root cause of the current problem is the same as the 2007 / 2008 collapse where liquidity essentially dried up. The event I am about to cover here has its differences to 2008 however the end result and basic cause are the same. When liquidity dries up the whole system freezes up. It does not matter about the fundamentals of companies or how the economy was travelling last quarter, how many housing starts or auto sales, none of that matters when the lifeline—money and credit—are severely disrupted.

For example Lehman Brothers Holdings Inc. held debt with 10 year maturity until the market downgraded this to 365 days, in the end they were reduced to only 24 hour finance. I don't know how many companies would survive that sort of stress test. This transition only took two months from relatively normal operation to bankruptcy and it was all down to, when you boil it down, to availability of credit. When a country gets downgraded the debt gets renegotiated and so it is also for a company or individual. This means that if Portugal for instance gets downgraded the terms of the debt they hold can change too. What may appear to be a sustainable interest rate or maturity profile can change at the stroke of a pen making the whole scenario very sinister indeed.

If you don't think this causes you any concern think again. Gold and gold stocks will be affected in addition to other asset classes.

There was already uncertainty after the stress tests in Europe however this was nothing to do with the results. As you all know, only seven banks failed out of 91. The problem for fund managers involved in the bond markets is that the data for Europe is now more transparent on all the banks. How are they going to buy Greek debt or Spain et al. when the numbers are right there in front of them? The funding counter party risk is not pretty here I assure you. The sovereign debt is tied up with the bank funding and company debt is there clouding the picture too. With growth poor this is only adding fuel to the fire.

If these managers buy this debt they may face all sorts of problems down the track if it can be proved that it was not a wise move. The major problem lies in the fact that the majority of the bond funds cannot buy unrated bonds in the giant international US$ Euro market. It takes somebody with experience setting up funds and running them to see this from the helicopter view. It also takes somebody with extensive macroeconomic smarts and substantial bond market experience to see this mess for what it is. We are back where we were in 2008 in many respects so you might like to batten down the hatches.

Disaster or Opportunity

When risk is off the AUD gets sold off too. We are currently up at US89c for the AUD as I write this article so there is plenty of downside risk—or opportunity depending on how you play it. If debt market conditions continue to worsen in the coming weeks as I expect we will see much lower levels on the AUD, not just US80c.

Europe and the U.S. are likely to go much deeper into recession than Australia longer term so this shorter term opportunity is going to be your chance to protect your capital or even score a 10 bagger if you live in the U.S. or Europe. Of course you will have to choose the right stocks and time the event properly. Any selloff in the gold stock sector here will present stupendous value as you will get a rise in the AUD back up on carry trade activity in addition to gold stock price appreciation.

In 2009 we saw many prime gold stocks quadruple off a very low base and the AUD also went up circa 50% in a little over a year. A few elite gold stocks went up much more netting huge gains for offshore investors as they also added the currency gains. Australian investors might also want to look at doing their due diligence on this gold sector ahead of the coming near term opportunity. There is currently no rush, which is just how we like to get prepared here at GoldOz. Take our time and watch your ideal portfolio selection approach price targets, know which ones you want to buy and what your weightings will be ahead of the pack.

This Australian gold sector has not had a broad based rally of any significance since 2006. 2007 was poor, 2008 was a disaster and 2009 was only coming off a very low base to produce those huge gains. That 2009 rally barely reached half of the 2007 levels that were well under the 2006 highs. 2010 has been a period where the spring is getting coiled tighter and tighter, with the odd tiny relief rally. Where will you be when this snaps? Will all your assets get caught in the U.S., UK. . .Europe perhaps? We have just introduced an exciting new free feature at GoldOz—interactive Australian gold stock charts and our GOLD ETF is there, too. The only listed gold asset on the ASX that appreciated in price during the last crisis was this ETF (ticker ASX:GOLD).

Good trading / investing.

Neil Charnock
goldoz.com.au

GoldOz has now introduced a major point of difference to many services. We offer a Newsletter, data base and gold stock comparison tools plus special interest files on gold companies and investment topics. We have expertise in debt markets and gold equities which gives us a strong edge as independent analysts and market commentators. GoldOz also has free access area on the history of gold, links to Australian gold stocks and miners plus many other resources.

Neil Charnock is not a registered investment advisor. He is an experienced private investor who, in addition to his essay publication offerings, has now assembled a highly experienced panel to assist in the presentation of various research information services. The opinions and statements made in the above publication are the result of extensive research and are believed to be accurate and from reliable sources. The contents are his current opinion only, further more conditions may cause these opinions to change without notice. The insights herein published are made solely for international and educational purposes. The contents in this publication are not to be construed as solicitation or recommendation to be used for formulation of investment decisions in any type of market whatsoever. WARNING share market investment or speculation is a high risk activity. Investors enter such activity at their own risk and must conduct their own due diligence to research and verify all aspects of any investment decision, if necessary seeking competent professional assistance.

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