On Wednesday evening July 10, Dr. Bernanke spoke for the Federal Reserve Board and saved the economy and markets, for now. He conceded that the bond and housing markets could not endure tapering of debt creation, falling bond prices and rising yields. Thus the tap remains open "for the foreseeable future." Everyone will come to the water and rising asset values and, perhaps corporate investment will generate jobs, spending and growth. That's the idea.
The market's July 11 surge does not mean the economy is well. On the contrary, it concedes that the economy is ill and that a withdrawal of virtual liquidity would crush the pseudo recovery. Dr. Stephen Leeb again noted, as John Williams has done several times this year that America is in a de facto recession and that ending Fed solicitation of Treasury debt would crush the markets. Rising bond yields would collapse the vast derivative markets and take down all economies. Analyses like those of Leeb and Williams, a major motif in my writing again were confirmed: the Fed backed away from taper talk when bond prices sank, yields rose and mortgage applications fell 28% as mortgage rates rose 22%. Williams noted (July 8, #540) that "money supply growth patterns indicate banking system stress." In this 6+ week stress test on QE, the 10-year T-bill yield rose to 2.69%, a 63% increase as the nominal value of all bond owners began to disappear. A systems' crash was pending.
We are safe for now: on paper our investments look great. But instead of partying, let's consider what the indefinite extension of QE means for PMs (precious metals) and miners, for the markets and underlying economy.
The last three months of action in the PM sector and general indices are almost mirror opposites: in the former, prices were crushed by short selling and subsequent margin calls, computerized stop-sells and panic till absurdly low valuations were reached. In the indices, mere hints of reduced infusions of electronic credit external to the core economy caused bond prices to plunge and stocks to wobble until assurance that stimulus would proceed. The result is that the indices may continue their tenuous rise, a financial sugar high, while the PM sector is primed for a powerful surge as commodities critical to industries, silver and the monetary and exchange systems, gold.
For the markets, extended QE means corporations will continue to borrow cash to buy back shares, inflating asset values by financial games more than by investment, hiring and productivity. Absent investment in core business operations, the PMI #s on employment will continue to drop as will the workforce participation rate. While the markets rise, the economy's ailments will grow. While I would love to be proved wrong one these matters, it is likely that at some point in the next two years systemic problems in all the major economies will merge in a storm of distress impossible to finesse further. At that point new socio-economic regimens will arrive. Austerity will be enforced for which the 90 - 99% will pay. If and when "globally active, systemically important financial institutions" (SIFIs) are bailed in, depositors will foot the bill. That's change: believe it. Safe havens will be in high demand.
Mr. Buffett's colleague Charley Munger drew ire last year when he said in effect that gold is only useful for people like Jews in Vienna in 1939, i.e. people needing to move pronto. That extreme and terrible situation is unlikely to recur (one hopes never) but many people will be hard-pressed if current asset bubbles burst (von Mises would say when they burst from "credit expansion"). One version of mobility I've noticed is the plethora of "for sales" signs in my town in a relatively prosperous corner of America. In 2009 people were selling in distress. Now they're trying to maximize gains before the bottom again falls out of the housing market. We began to get a taste of this in June as purchase contracts were cancelled and applications plunged while mortgage rates rose, the 30-year fixed to over 4.7%, historically low but highest in three years.
Part of what was crushing PM prices was the unwinding of leveraged trades and margin and computer selling triggered by short sell guidance and low ball estimates on futures. As prices have been crushed and Asian and retail buying has risen, the major warehouses have found themselves short of physical metal. Belatedly orders are being filled as bullion banks borrow in LBMA (London Bullion Market Association) GOFO (gold offered forward) swaps to fill some of the most pressing orders. COMEX gold stocks are down 32% YTD. The Shanghai Silver Exchange since April 12 has depleted 45% of its stock filling orders. This matrix of price suppression, strong demand, short supply (as E & D are cut or slowed), maximal negativity in sentiment and extreme contrarian appeal and value compressed the spring beneath mining prices: on July 11 prices snapped back powerfully with gains of 3 - 10%. July 12 saw a slight retracement on very light volume. Assurance from the Fed of increased debt stimulus was the proximate catalyst igniting PM mining prices that already were rising. Banks ("commercials") have gone strongly net long for gold and silver increasing the positive outlook. Gold continues to move from West to East as buyers "prefer to hold physical metal rather than futures" contracts.
Buying of gold and silver by retail investors in Asia and North America remains very strong. India is heading for a record year of retail silver purchases as the PBOC is for acquisition of gold. Bullion prices seem to have made their lows when gold briefly dropped below $1140/oz. and silver to $18.70/oz. Both rose substantially last week. Note that until the past six weeks, PM ETPs fully backed by metals and the mainly paper contracts like SPDR Gold (GLD) and iShares Silver (SLV), useful vehicles for futures trading by big players, tended to act similarly. Some days Sprott Physical Gold (PHYS) or Silver (PSLV) would perform a bit better than their far better known paper counterparts, some days less well. However, since May 22 when bond yields began rising the physical-backed ETPs have nearly always outperformed GLD and SLV. This is one signal that gold and silver have finished correcting.
It is not only accommodative fiscal policy, Asian CB and global retail purchasing that is beginning to unleash the next leg of the secular bull in PMs. The volatility that in due course will hit markets built on debt and above organic weaknesses and contraction in the major economies (and the emerging economies dependent on them) will increase flight to safe havens, cash, mega-cap dividend payers and PMs. One simply can go primarily into cash when enormous volatility and increasing triple-digit red days reappear as QE wears off but don't expect the Fed to ride again to a dubious rescue as with "TARP" and its sequels. A different regimen is coming and though it may be called "recovery" it is more likely to look like a dystopian novel.
In the meantime, make hay while the sun shines and the spigots are open. It's time to nibble on the indices again and increase portions of your favorite companies. As I have written often, the major mixed commodity miners like Rio Tinto (RIO), BHP Billiton (BHP) and especially Freeport McMoRan (FCX) which now is a copper, gold, molybdenum, gas and oil titan have deep value and strong dividends: 4.2%, 3.7% and 4.4% respectively. Trading at depressed levels, their upside and sustainability is large even if economies tremble. They have massive reserves, cash flow and credit access. Note that RIO is set to become and FCX already is a major producer of gold and that they have a 40-60% partnership at the Grasberg Minerals complex in the mountains of West Papua on the island of New Guinea in Indonesia. Open pit mining operations resumed there June 25 and full operations resumed July 10.
But the best values remain in the PM mining sector. A rising tide is coming that will lift all boats but let's focus on the best in each cap size and type. Goldcorp (GG) is the major producer with the best balance sheet. Its cash and equivalents/debt ratio is 8:9, its debt/equity is a tiny .1 and it yields 2.3%. It has net income of $1.58 billion on revenue of $5.1 billion and a solid cash flow of $2.35 billion. In the mid-tier gold space I continue to favor Eldorado Gold because of its sound financial status: cash & equivalents 4:3/ debt and .1 debt/equity ratios that distinguish it favorably from larger mid-tier producers Kinross Gold (KGC), Yamana Gold (AUY) and IamGold (IAG). IAG has a fine 7:6 cash and equivalents / debt ratio but its revenues have declined 24.6%, the same amount that EGO's revenues have grown and are likely to grow further. EGO yields 2.1%. KGC's debt to revenue is manageable though not good at 2:3 but its negative income, -$2.45 billion and diminished growth outlook, partly from the break with Ecuador over the Fruta del Norte site are daunting despite a nice, for the present, 3.3% dividend. AUY carries total debt 130% higher than its cash and equivalents. Its cash flow covers 88% of its total debt but revenues are -4.4%. This is not terrible given the likelihood of a strong rise in gold prices but if you want to choose one mid-tier EGO looks best to my view.
In the small cap gold space, McEwen Mining (MUX) has held up best in the difficult YTD. In 2Q it reached new highs in output at 36k gold equivalent oz (21k gold oz. and 778.3k silver oz.) from its El Gallo I mine in Mexico and its 49% stake in the San Jose mine in Argentina it owns with Minera Andes, a subsidiary of Hochschild (OTCPK:HCHDF). El Gallo I which has produced 15k oz. gold and 12k oz. silver YTD is being expanded 50% this year and development of El Gallo II as a heap leach site is being explored without incurring debt: MUX remains debt free. Even a modest rise in prices should send these shares back well over $3. They closed Friday at $1.88.
First Majestic Silver (AG) is to me the best of the silver miners. It has seven excellent mines with the richest, Del Toro nearing full production in 2014 and already adding to rapidly growing output (55% increase in gold and silver YTD), cash flow, and revenue and income growth. AG's debt is negligible and it is rated "strong buy" with a consensus target of $20/share, 66% above its Friday close. Dundee Capital cite Tahoe Resources (TAHO) for the best single property, its Escobal mine in Guatemala. However, it is not producing, is plagued by outside agitators of doubtful provenance and its eggs are all in one basket so to speak. With seven mines and a basket of excellent E & D sites that will push forward as Ag (silver) prices rise, AG is the prime choice. Both companies are about 5% of the silver miners ETF (SIL).
Among streaming companies, Silver Wheaton remains premier with Dundee Capital (previous link) citing it for a business model that would work even were silver to fall to $15/oz. which is not likely to occur absent a depression and perhaps not even then. Still near a 3-year low at $20.47, SLW is a great buy even without the 2.3% dividend. It expects its contracts to yield 33.5 million oz silver this year. Sixteen major analysts rate it "strong buy" with a target of $35.31, 75% its Friday close. Franco Nevada (FNV), a gold, silver and energy royalty company has no debt, 3.6% revenue growth and good cash flow and a 2% yield. If you want a value play with a hefty 5.2% dividend, massive $15 billion reserves and price grossly suppressed by hostile sentiment and over-rated headwinds, Barrick Gold (ABX) at its current levels is a contrarian play likely to reward investors with a 2-4 year time frame.
The Fed's pledge of continuing liquidity has bought time for markets and an economy with many troubling fundamentals. Perhaps the stay of execution can be used to amend organic issues. In the meantime, the biggest values are in the PM mining and mixed commodity mining sector generally. Good and safe plays also are in giants like United Tech (UTX), Union Pacific (UNP), health care (VHT) and the resurgent consumer staples (VDC) sector. The Fed's decisive reversal though not set in stone should provide at least 2 more quarters of running room for equities. For the mid and longer term, the climate has not changed. The emergence of a new monetary and reserve system and the pressure of powerful demand likely will produce a new and long leg in gold's secular bull. It again will demonstrate its age-old character as a store and measure of value.