“Prediction is very difficult, especially about the future”—Niels Bohr
The quotation from the great physicist Niels Bohr begins this post, as acknowledgment that the forward-looking statements below include both explicit and implicit predictions of rising inflation and a corresponding rise in the market value of assets that cannot be inflated in quantity by the actions of the state in debasing its monopoly supply of money. In the view of the author of this post the predictive problem is not whether, but when Americans will see large-scale price increases due to the federal state’s manipulation of its monopoly supply of money.
In two prior blog posts entitled Your Money and Your Life, posted March 22, 2013 and May 2, 2013, we examined the deliberate debasement of the U.S. dollar that has been going on since 1933, and which has intensified since the financial crisis of 2008.
In this third installment of comment on monetary debasement by the United States federal state, we bring to our readers some recent and illuminating observations of Darren C. Pollock and David A. Horvitz of Cheviot Value Management, LLC (Cheviot). That firm was co-founded in 1985 by Frederic G. Marks, author of the prior posts entitled “Your Money and Your Life,” and “Your Money and Your Life, Part 2.” Frederic G. Marks is the proprietor of the website of which this blog is a part. These comments are quoted from the most recent newsletter of Cheviot, which can be viewed at http://cheviotvalue.com/ and specifically at http://cheviotvalue.com/wordpress/wp-content/uploads/2010/10/Investment-Values_July-2013.pdf 1
This blog post will be most informative to those who have read the two previous posts on Your Money and Your Life. [NOTE: Text in brackets signaled by the capitalized word NOTE is interpolation of the author of this blog.]
Margin debt borrowed against investment accounts recently reached an all-time high. 2 Previous records coincided with stock market peaks in early 2000 and summer 2007. And those peaks were followed by major declines. As a percentage of the overall economy, margin debt is now almost 170% greater than it was on the eve of the stock market crash in October 1987. One reason why high levels of margin debt make for a potentially dangerous environment is that the borrowed money which funded stock purchases will need to be repaid quickly should there be a significant decline in share prices. Selling stocks to meet margin requirements or pay back loans could easily compound the decline.
With U.S. property prices levitating in large part due to low interest rates and bank-suppressed inventory, investors are commonly turning to margin debt from their stock portfolios, not just to purchase more stocks but, to fund speculative purchases of real estate. This high-wire act should only be performed by the most sophisticated investors, those knowledgeable of the risks involved. Borrowing against one’s stocks to buy real estate shows, in this case, that history rhymes. For it was in the stock market mania of the late 1990s when individuals regularly turned to their home mortgage as a source of funds for buying into the most overpriced stock market ever. . .
Is the Fed trapped?
In response to the 2008 economic crisis, the Fed quickly lowered interest rates to zero and then stimulated further by purchasing (thus far) $2.5 trillion of available mortgage securities and U.S. debt (known as “quantitative easing” or “QE”). This rescue effort is aimed at keeping interest rates low and increasing the solvency of large banks. The scope of this stimulus is unprecedented in U.S. history.
While the Fed has not waivered from its zero interest rate policy since 2008, it has varied the pace of purchases under its QE programs, increasing stimulus, decreasing stimulus, stopping stimulus, and restarting it all over again. Each time there was a pause in Fed purchases, the stock market declined significantly, and before too long, the Fed resumed its stimulus, relieving the markets and sending them higher. By now, the Fed has made an addict out of the markets. Says monetary policy historian, James Grant: “You can’t just do a little QE. You are stuck, you must keep on doing it and doing it and doing it.”
Grant continues: “Which to me makes the selloff in gold that’s been relentless even more anomalous. The Fed is coming out and telling you that they are not going to do less of what they’re doing barring some sudden upsurge in activity which seems quite unlikely.”
By increasing stimulus when needed, the Fed has a history of being friendly toward the markets and banking industry. Recall the Y2K fears of banks ceasing to function properly in response to a software bug not recognizing the new year. To prevent feared financial fallout, the Fed provided roughly $35 billion of additional liquidity to banks in the final months of 1999. . .
The $35 billion that Alan Greenspan used to support the banks in 1999 helped push already inflated stock prices even higher. After Y2K arrived without the feared banking consequences, the Fed was free to withdraw this injection of liquidity. If stock prices were in a bubble, the withdrawal of liquidity may have been the pin. From the first quarter of 2000 through the end of 2002, the S&P 500 plummeted nearly 40%.
Since 2008, the Fed has stimulated by more than 70 times the amount of late 1999. It is now stimulating at the pace of a Y2K injection every 12 days. So dependent is the market on monetary stimulus that it declines every time the Fed does so little as talk about reducing the pace at which it adds stimulus, never mind suspending stimulus or withdrawing it altogether. Surely the Fed knows that weakness in the economy has prevented it from ceasing stimulus. It must at this time know that there is no way for it to actually withdraw the $2.5 trillion worth of injections without crashing the markets and economy. As a result, this money will remain available for banks to use when and as they see fit.
So far in 2013, the Fed has purchased a staggering amount, near 80%, of all bonds issued by the U.S. Government. [NOTE: That is literally one arm of the state creating money out of thin air for another arm of the state to spend. This is the epitome of inflation, in the money supply, which must eventually produce rapidly rising producer and consumer prices.]
This demand for bonds kept prices high and yields low, but recent talk of a reduced rate of Fed purchases crushed bond prices and sent interest rates soaring. 30-year fixed mortgage rates quickly climbed from 3.5% to more than 4.5%. This counteracts the Fed’s goal of increasing housing prices through low interest rates. Without a way to increase employment directly, the Fed has wished upon the “wealth effect” whereby it hopes that higher housing prices will make consumers feel wealthier, thus encouraging them to spend more. Rising rates may extinguish this hope. . . .
[NOTE: From 1992 to 2006 interest rates on mortgages ranged from 5.5% to 9%; rates were never below 5.5%.] 3 If mortgage interest rates were to increase to 5.5% the monthly payment on a new mortgage would be 26% higher, and the market value of the home would fall 21%, subject to the universal qualifier in economics—all other things being equal. 4
With this in mind, we ask: How can the Fed possibly allow interest rates to increase? Or, said differently, we expect the Fed to do all within its power to suppress rising rates. Higher borrowing costs are already hampering the housing market. Housing and housing-related commerce is a major driver of economic activity. It comprised nearly 70% of the first quarter’s anemic GDP growth. A reduction in housing demand would most certainly restrain economic growth. Simply put, the Fed must fuel the housing market with low interest rates; otherwise, the U.S. economy will suffer.
Says interest rate expert and “bond king” Bill Gross: “We’re in a highly levered economy where households can’t afford to pay much more in interest expense. Monthly payments for a 30-year mortgage have jumped 20% to 25% since January. Mortgage originations have plummeted by 39% since early May. High levels of leverage, both here and abroad, have made the global economy far more sensitive to interest rates… If the Fed were to hike rates or taper [stimulus] suddenly, the economy couldn’t handle it. [Bernanke] badly wants to avoid the mistake of premature tightening [raising of interest rates], as occurred disastrously in the 1930s.”
Today, the market maintains faith in the Fed’s abilities to see and steer our economy. Yet this is the same Fed whose loose monetary policies caused the housing bubble and subsequent financial calamities. Moreover, for many years now the Fed has been optimistic but wrong about the economy. Recall just this smattering of absolutely egregious errors of wishful thinking:
- 2006: Home prices will keep rising;
- 2007: The subprime mortgage disaster will not spread nor harm the banks or economy;
- 2008: Fear not the financial footing of Fannie Mae and Freddie Mac;
- 2008: The economy is not headed toward recession;
- 2009: The Fed will not monetize U.S. debt [NOTE: QE is debt monetization!]
Following the greatest economic decline since the Great Depression – which the Fed did not see coming – the Fed has consistently been wrong about its ability to end or withdraw its stimulus program. It overreached on expectations for economic growth in 2010, 2011, 2012, and again so far this year. The Fed talked in late June about “tapering” its stimulus in part due to expected economic growth in the first quarter of this year. The Fed expected growth of 2.4%. Actual growth was revealed to be 1.8%, another huge Fed miscalculation. It is being “far too optimistic,” says Gross. He calls their expectations of 7% unemployment by the middle of 2014 “a long shot.”
Yet the market continues to believe that the Fed will, for the first time, actually end its monetary policy and – confounding as it may be – do so with neither negative nor unforeseen ramifications. The market today may be forgetting that the economy is reliant upon artificially low interest rates. Few market participants care to remember right now that the Fed quickly reverts to more stimulus whenever the markets or economy slump.
Bond investor Jeffrey Gundlach reminds the market: “If we slow down quantitative easing, don’t take it as a sign that it won’t come back again. If interest rates are going to rise, it means quantitative easing was a total failure. It means the budget deficit of the U.S. is going to explode into a massive crisis. It means housing is going to crash, because it is interest rate based.”
QE, he continues, “is not a solution. This is a temporary way of keeping things together, while somehow hoping that global growth appears, but that’s not going to happen. What you’ve got is this policy that’s very short-sighted and will have immense long-term consequences. It will spiral out of control.”
So the Fed is faced with a dilemma. It can end its stimulus programs which could easily cause a significant near-term economic crisis; or it can continue to monetize the majority of newly-issued U.S. debt, keep interest rates extremely low, and face longer-term inflationary problems. Our modern day Fed avoids short-term pain at all costs, suggesting to us that the Fed’s policy of QE will continue longer than the market currently expects. In our view, leaving a future mess for his successor will be the only “exit strategy” Chairman Ben Bernanke employs.
CERTAINLY NO TIN CAN
Historically the price of gold is more likely to rise when the market anticipates increased inflation and is more likely to decrease when the market expects deflation. Many attribute this year’s lower price for gold to selling caused by fears that the Fed will permanently end its stimulus thus risking deflation more than inflation. To us, it is unlikely that the Fed will end its easy money policy in the foreseeable future, especially given the shaky footing on which rest today’s elevated stock and housing markets. Upon the mere mention of a reduction in stimulus, financial markets fell and housing affordability dove in response to higher mortgage rates. Consider the apple cart upset.
This quarter’s gold price decline has been met with immense worldwide demand for the physical metal (contrasted with the “paper” version of gold being sold on exchanges), especially in Asia. (Such was also the case in 2008, when deflationary fears sent the gold price down by more than 30%, creating a wonderful buying opportunity). Worldwide demand reduced the supply of available bullion causing individuals to pay high premiums over the market quoted price. In our view, much of the record-setting quantities of recently acquired physical gold will likely not become available for sale again for quite some time. We view this as supply that may have been permanently taken away. This could be particularly true in China where gold stockpiles are growing as a way to diversify away from their holdings of U.S. Treasuries. . .
When an asset class declines in price, usually the loudest market response is the contingent which decries its value and forecasts a continued swoon. Gold, as an asset class, is obviously not immune to this call. Says The New York Times: “The most recent advisory from a leading Wall Street firm suggests that the price will continue to drift downward, and may ultimately settle 40% below current levels… The sharply reduced rates of inflation combined with resurgence of other, more economically productive investments, such as stocks, real estate, and bank savings have combined to eliminate gold’s allure.” The New York Times stated this on August 29, 1976. It had no way of knowing at the time that the bear market in the price of gold ended four days earlier. . .
A Time magazine issue dated August 2, 1976 ran a piece titled, “The Great Gold Bust.” This story referred to gold as having “as much luster as a rusty tin can” and stated, “The economic conditions that triggered the gold boom of 1973-1974 have largely disappeared.” Fed Chairman Arthur Burns was proclaimed a hero for orchestrating a comeback without the side effects of inflation. (This should remind you of the current opinion of the Fed.) Readers of Time could not have received worse advice. The price of gold reached its low within days of this widely read article. The gold price then marched higher by more than 700% over the ensuing four years. Gold mining stocks performed extraordinarily well.
Considering the changes in the market price of gold throughout the entire decade of the 1970s, the tortuous bear market of 1976, similar to that which we are experiencing today, appears as a mere pothole on the highway to dramatically higher prices. . .
Investors in 1976 and 2008 who were able to withstand the deluge of misinformation and hold on or buy more precious metals investments were eventually glad they did. These investors recognized then, like today, that monetary policy was a friend of the price of gold. Today the Fed can only talk about reducing the pace at which it continues to increase the monetary base. There is no discussion at all of reversing the monetary stimulus which has been put into the economy. This is where so many investors today get it wrong when they compare gold’s price now to the fallout from the high price for gold in 1980. Then, the Fed 5 was restricting the money supply and raising interest rates dramatically in an effort to thwart inflation. Today’s Fed is stimulating by tremendous sums, keeping interest rates at zero, with the goal of increasing the rate of inflation.
Bernanke is today considered to have orchestrated a maneuver whereby a great depression was averted, stock prices were returned to pre-crisis highs, real estate is levitating again, inflation is not to be feared, and the Fed can withdraw its unprecedented stimulus without sending the fragile economy into a tailspin. “Folks, if you believe this fairy tale,” says extraordinary investor Fred Hickey, “then you are not unlike the poor dupes who panicked and sold all their gold right at the bottom in the 1976 gold capitulation.” Hickey continues: “Here’s the difference between now and the 1970s: [Then Fed Chairman Arthur] Burns’ easy money policies were minor league stuff compared to what the Fed, Bank of Japan, Bank of England, Swiss National Bank, and others are doing today. The inflation risks today are orders of magnitude greater than in the 1970s, when there was no quantitative easing, no quadrupling of balance sheets, and no trillions of high-powered reserves printed out of thin air.”
Supply Shortages May Cause Higher Prices
While money can be printed, gold cannot. In response to fears that its gold might not be where it thinks it is – or in the quantity it expects – Germany earlier this year requested a withdrawal of some of its gold from various global storehouses. With more than 1,500 tons of gold held in a vault at the Federal Reserve branch in lower Manhattan, Germany’s request of 300 tons should have been granted easily. Not so. Germany will need to wait seven years before receiving all 300 tons that it requested. While the U.S. says it will eventually return the small portion of Germany’s gold that it demanded, the largest Dutch bank, ABN Amro, told its clients that all requests for their gold will instead be paid in cash. For years, people in the gold community have pondered whether there is as much gold available as statistics show or if there is an unknown shortage. The above examples are just two which lend credence to the latter.
The lower recent gold price will reduce global gold production as new projects and less economic ones are shuttered. Market perception regarding this potential reduction in supply may help support the price of gold. Moreover, the market’s recognition that there may be a major shortage of gold would likely cause a sea change in today’s dismal sentiment for gold.
Currently, nearly every index that measures investor attitudes toward gold is at an extreme if not all-time low. One measure indicates that bullishness is squarely at 0%. The gold market now represents fertile ground for the contrarian investor to cultivate.
Contrarian investors often focus on the errors in pricing that markets create when sentiment is carried too far. Currently, valuations for gold mining companies are at remarkably low levels. Based on price-to-cash flow, the shares of large gold mining companies have in previous years traded within a range of 6 to 26. Today’s level is 6. Similarly, price to book value (a measure of the market price against the net worth of a company) has ranged between 3.6 and its 2008 low of 1.0. Today’s level is 0.91, below that of the 2008 global selloff.
At today’s prices, an investor could buy all of the shares and debt of the largest gold mining companies, liquidate the businesses, and make a considerable return on their investment. Because of this more than theoretical option, levels such as these have often provided a floor under a bargain share price. Such valuations are rare and have historically attracted interest on the part of investors. In this way, low valuations can result in higher prices. When there is intrinsic underlying value, good things usually happen to cheap stocks.
Dividend yields for today’s large gold mining companies are substantial. Many mining companies offer income levels greater than those of long-term bonds. It is no wonder that gold company insiders are buying back shares. Says Ted Dixon, expert on insider transactions: “Such a high level of buying interest among officers and directors within their own businesses in the resource sector has correctly foreshadowed a recovery in share prices in the past.” The last time such a level of insider buying existed was during the opportunity-rich 2008 meltdown.
Valuations and insider behavior may speak volumes to us, but they are no match for human nature. This is because human emotions are usually in perpetual battle with investment prices. High prices make people feel good and trigger them to want to buy more. Low prices the opposite. While people flock to sales for discounted goods and services, they typically run from cheaper prices of investable assets. Just as lower prices darken sentiment, it is too often overlooked that lower prices also set the stage for positive future performance. Moreover, lower prices increase the chances that future returns will be greater than currently expected.
When any asset class falls out of favor on Wall Street, it usually becomes priced so low that it makes little sense to sell and much sense to hold (or buy more), awaiting the turn in sentiment. Keep that which is cheap. After a decline, studies show that industry groups tend to rise dramatically over the ensuing three years. Since the 1920s, a 60% decline in an industry has resulted in a rise of 71% within 36 months. Furthermore, any time the gold mining industry has performed as it has in the last 18 months, future returns are substantial.
There are six previous periods in which gold mining companies have similarly underperformed relative to the general stock market. The average return following such periods is a gain of 221% in little more than one and a half years.
This is because bear markets give rise to bull markets. The nature of the recent decline, coupled with what we see as fundamental support underlying the precious metals, causes us to believe that we could see explosive positive performance from our gold-related investments.
Contrarian and value investor Marc Faber agrees: “Gold shares are extremely depressed,” he said in June. “I think there is an opportunity for a relatively sharp rebound in gold shares.” Faber correctly analyzed and avoided bubbles during the last couple of decades by capitalizing on opportunities for safe investment in beaten down industries and markets. He is not alone among a small group of investors who safely navigated their way through major market surges and meltdowns of recent history. We closely study these investors whose wisdom rings far truer to us than the opinions of others who cannot boast similarly successful long term investment performance.
One such successful investor, Bill Fleckenstein, does not mince words: “The smart money is set up [invested] one way and the so-called dumb money is set up differently. The people that have been pretty good at understanding the difficult environment we’ve been in for the last 15 years all tend to be bullish on gold and the ones who never understood any of it all tend to be bearish. What do you want to do? It’s pretty simple as to what side you want to be on.”
The Fed today continues on a path that we recognized beginning in the late 1990s. We then saw an overpriced stock market that, when it eventually burst, would cause the Fed to over-stimulate. That overly aggressive response to deflation fears would spur a bubble elsewhere in the economy (housing) whose eventual demise would spur tremendous action on the part of not just the Fed but central banks throughout the world. The debts accumulated throughout this process would require many years of stimulus, including monetary expansion, which would eventually stoke fears of inflation. We believe that we remain headed down this path. Easily within the next couple of years we expect there to be a smarter and better time to sell precious metals holdings. By that we mean when prices are higher and when the market, abiding by its cyclical nature, favors gold-related holdings once more.
Jim Rogers, a member of the elite of “smart money” investors, says he’ll sell his precious metals “when there’s a bubble in gold.” Though he does not know when this will be – timing is unknowable in investing – he continues, “We haven’t seen a bubble yet.” While today many Americans are selling their gold, as evidenced by the number of dealers and stores buying from individuals, “Later, there will be signs that are saying, ‘We Sell Gold,’ and people will be lining up to buy it in big ways. That hasn’t happened yet.”
- Frederic G. Marks is no longer involved in the operations of Cheviot. The firm’s business is being carried on capably by Darren Pollock and David Horvitz. ↩
- NOTE: Margin debt consists of borrowings by owners of accounts invested in marketable securities, particularly common stocks. Under current federal regulations the owner of securities in a stock brokerage account may borrow up to 50% of the value of the securities, by means of a loan from the stock brokerage firm. Borrowing on margin is a risky business, because if the value of the securities in the account goes down the account holder is required to add enough cash to the account to restore the value of the account to twice the amount of the margin loan, which may be inconvenient, difficult, or impossible for the borrower to do. Margin borrowing can lead to loss of the entire value of a stock brokerage account, because the brokerage firm is entitled to sell all securities in the account to satisfy the loan obligation. ↩
- Mortgage-X Mortgage Information Service, http://www.mortgage-x.com/general/historical_rates.asp ↩
- The mortgage referred to in this discussion is a hypothetical thirty-year fixed rate mortgage qualifying for Federal Housing Administration Insurance.] ↩
- Under the leadership of Fed Chairman Paul Volcker ↩