How you answer this question reflects your outlook on American and global economies. My premise is that we are five years into major restructuring of the world reserve system, consequent currency and trade reorganization that will include new centers of diplomatic-financial power. I believe that American fiscal policy symbolized by QE is part of lowering American socioeconomic strength and stability as power shifts to East Asia and the world to a triadic structure that will operate by managed attrition. While wealth creation and "democracy" (as, for example, in Egypt) get increasing lip service, policy making is becoming more oligarchic and finance more opaque, a trend in place since Teddy Roosevelt was in office.
My suggestions for investment and allocation derive from the above outlook and include precious metal (PM) bullion, miners and streaming companies. There also are some equities that should do well in the conditions noted above. While I hope for true and broad-based economic recovery and market strength, beyond this year I think that scenario is unlikely to be often in place.
The logic for the current appeal of the PM sector has been addressed by Dr. Keith M. Barron, an acclaimed geologist, respected equities strategist and Director of Solidus Resource Management. Barron believes that the combination of declining gold inventories in COMEX, SPDR Gold (GLD), Brinks and other Western depositories, radical cut backs in E & D by PM miners resulting from steep YTD drop in PM prices and the fact that supply will never reach its recent highs puts us in a "peak gold" situation that will support steadily rising prices. This will join a gold-backed RMB to sustain a bullish case for PMs and physical metal ETPs like Sprott Gold (PHYS) and Silver (PSLV). Barron points to the "backwardation" of gold (when current prices exceed gold futures because of uncertainties about availability of physical metal) as an indicator of a strong lift pending for PM prices. Art Cashin, NYSE floor manager for UBS also recently addressed this situation.
Barron adds that at lower gold and silver prices, mining companies are ceasing to produce from lower grade ores. With most of the higher grade ores either exhausted or more costly to develop and work (as in South Africa), the peak gold effect has increased. China continues its massive purchases of gold and it keeps all its own gold output, 370 tons/year in the world since 2007. In Vietnam sellers are charging premiums $217 over spot for gold bullion. Conditions for a resumption of rising PM prices is in place. I discussed this in my articles on the duration of corrections in the 2001-11 bull and the steady increase in the size of each rise.
I do not believe that primary asset classes generally are now as safe an investment as the depressed PM sector. Consider what happened to bonds, REITs and equities May 22 - June 28 when "taper talk" dominated financial news. From an intraday high of 1684, the S&P fell 100 points in five weeks. Similarly, on the assumption that the Fed would begin reducing its purchase of national debt, bond yields and mortgage rates spiked (the 10-year T-bill from 1.61% to 2.65%, 30-year fixed to 4.43%) as the nominal value of bond holdings tanked. "Optimism on the housing recovery has gotten ahead of the fundamentals," Lance Roberts wrote July 26. New and existing home sales, permits and starts, even with $30 trillion in Federal support have returned only to half the levels of 2006. If and when QE is tapered, there will be socioeconomic carnage.
The results of the taper-talk stress test made clear that the equity and bond markets need QE and that withdrawing it will cripple the housing sector and the rest of the economy. That is, our economy is suicidal: it depends on debt creation. Consumerism and consumption in the medical sense correlate. This context is my skeptical-pessimistic view on the major asset classes.
The 2008 crisis and crash involved the housing collapse and bank solvency ("credit crunch"). It was fixed by the Fed creating $7 trillion in debt to suppress borrowing and repayment costs. That will not work next time because bank debt (still extreme if one considers derivative exposure) is not now the main problem: Sovereign debt is. The deficit spenders in DC, Brussels, London and Tokyo have been inflating away debt and radically devaluing their currencies. Bond holders including most seniors have been damaged.
When Sovereigns start tottering and hundreds of trillions in derivative contracts catch fire, the results will be an instant need for Sovereign and SIFI debt relief. They will re-capitalize themselves by some combination of defaults, taking a portion of depositor accounts ("resolving globally active systemically important financial institutions") and transforming retirement accounts into holding pens for Treasury Bonds.
Any of these paths, especially the latter two, will wreak havoc with markets, transform America into a two-tier society and radically restructure socioeconomic relations. If you don't think those would be the results or that this outlook is plausible, remain bullish on equities.
Note that most analysts, like Timothy Hoyle of Haverford Investments told Bloomberg July 26 that "fundamentals are not going to support a run higher." Additional earnings growth this year, he stated, would result from cost cutting, operational efficiencies and lower interest costs not from organic business growth. The need of businesses for low interest costs puts added weight on the Fed continuing QE and emphasizes market dependency on debt creation.
An analyst at JPMorgan said that "rising rates do not mean the death of equities" (previous link). That probably is true but the health of the markets also depends, ultimately, on the viability of the economy and in the past 40 years the economy has been structurally damaged by outsourcing, demographic and industrial decline, destruction of jobs by technology and currency devaluation. It is hard to see a substantial reversal in any of these trends though people should continue to work for remediation.
Russian bond markets are being distorted by large influx of foreign investment which now constitutes 30% of Russian bond holdings. It is easy to see why Westerners seek out these instruments: Russian ten-year bonds yield 6.48% and that is the lowest rate in five years, share price rising and yield dropping on massive buying. So QE policies in the West and Japan are disordering bond and equity markets throughout the world. This does not augur well for the stability or continued rise of these asset classes.
In several articles I have noted the inverse condition of PMs vs. equities and bonds: after gold's top in 3Q 2011 and Silver's in 2Q 2011, PM prices went into a descending plateau with strong support for gold at $1550/oz. The early 4Q 2012 high at $1792 was a bit more than halfway into that plateau's duration. This 18-month interim or correction period did not end naturally but from short selling, consequent computerized stop-sells, plunging sentiment and panicked risk-off trades. The current backwardation and increasing strong demand in the face of falling physical stocks reinforces the view that this plunge in PM prices and PM miner profitability was artificial and transient. While chatter on the PM drop has been relentless, few note the equally important YTD 29% plunge in corn, nearly as deep as silver or the 16.2% drop in wheat, nearly as bad as gold. Copper (JJC) down 15% YTD augurs poorly for global growth. BHP Billiton (BHP) sees near-term Cu (copper) prices at $3/lb and the copper miners ETF (COPX) remains near 52-week lows. While the board was red for nearly all commodities July 26, PM ETPs (GDXJ), (GDX) and most miners, Newmont (NEM), Barrick (ABX) were solidly green. On July 29, general declines were avoided by Junior Silver Miners (SILJ) +2.46% and Global X Uranium (URA) +3.72%.
Capital manager and hi-tech innovator Dr. Stephen Leeb sees physical gold and silver "as the primary way for people to protect their savings." Analyzing the factors making the yuan-RMB central to a gold-backed world reserve currency, he anticipates a 6-8 fold rise in gold in the next five years. This scenario already is in process.
Caterpillar's (CAT) 2Q results support the gist and inference of this discussion. Net revenues fell about 17%, profit/share about 36% and net profit over 40% Y/o/Y. That suggests that the overall business efficiencies of this giant of global growth and health began to break down as revenues declined. S&P asset values are up 19% this year but revenues only 1%. Something's going to give.
Bond and equity prices are artificially inflated while PM sector prices still lag. Given the skill of the Fed in helping direct asset values higher, you need to be in these markets if you wish to maximize growth. However, because inflated prices mask declining revenue and profit growth and low yields, the costs of Fed policy are accumulating. This makes a case for increasing cash or positions in short-term corporate bonds (VCSH). A harsh correction in equities is unwelcome but due.
Regulation and fines (forms of taxation) penalize building and industry so look to companies in tune with demographic and sociocultural trends like McDonald's (MCD), TJX (TJX), Altria (MO) and Coke (KO). I prefer Altria to Philip Morris (PM), for MO's higher dividend and lower share price resulting in rapid accretion of share holdings. Foreign governments are raising excise taxes on cigarettes and this has been cutting profits for Phillip Morris. Arie Goren has made a strong case for the fundamentals of Lorillard (LO). Penn National Gaming (PENN) is 17% off its YTD high and has overweight ratings. Pinnacle Entertainment (PNK) has had a strong YTD, up 25% and a superb 52 weeks, doubling in price. In five years it has risen 400%, its lift profile a more jagged type of the smooth up trend of TJX. Like PENN, PNK's Quick Ratio is okay, just above .90.
For macro reasons including years of upcoming volatility and socioeconomic and geopolitical stresses, I retain a preference for large, mixed-commodity miners with geographically diverse sites and deep reserves that pay substantial dividends. Still value buys, if world economies recover they will run and companies like CAT and DE will rise. In rougher waters, major mixed-commodity miners and energy producers still will have buyers and are likely to become even more integrated with government and NGO power groups and policies. Look to companies like Freeport-McMoRan (FCX), Rio Tinto (RIO), BHP, Royal Dutch Shell (RDS.B), Exxon (XOM) and Chevron (CVX) to endure and spin off cash. Chemical giants Dow (DOW) and DuPont (DD) should do well as should transport giant Union Pacific (UNP) with its .9 quick ratio, big $5.9 billion cash flow and $21 billion in revenues.
Among sectors, I still believe that Health Care (VHT) and Consumer Staples (VDC) are the safest plays. Fidelity's Biotech fund (FBIOX) leads its peers' average annual returns of 40-48% for 3 years. If the next correction passes without leaving a major recession in its wake, Consumer Discretionary (VCR) should run again with the entertainment and consumption plays noted two paragraphs above.
Global finance, trade and geopolitics suggest that it is in the PM sector that the greatest values with some of the strongest growth potential are to be found. The emerging world system will have a place for gold decided by China, India and Russia which also is accumulating though more slowly: it is the world's 4th largest gold producer. Western economic, military and financial suasion, amplified by the genius and reach of its media will joust with the holders of real wealth, the pattern Orwell foresaw in his novel of endless attrition and general impoverishment. I like United Technologies (UTX) for its intrinsic merits and as fits the times. I believe there also will be growth in the Nuclear Energy (NUCL) and Uranium Mining sector.
Major producers of gold and silver with many sites in safer jurisdictions (North America, Scandinavia, Europe, Katanga and, as of now, Indonesia) will be integral to the new world system. Goldcorp (GG), Barrick and Newmont should prosper. NEM has immense $9 billion reserves, second only to ABX at $15 billion, and yields 4.7%. GG's quick ratio of 1.54 is far better than CAT's. Eldorado Gold (EGO) has a 3.8 quick ratio, 4:3 cash to debt and multiple producing sites. It has halved its E&D budget for 2013 to await higher prices and control current costs. Silver Wheaton (SLW) because of its diversified contract - partnerships and minimal overhead and First Majestic Silver (AG) for its revenue and earnings growth, numerous productive sites and pending development projects respectively look best to me in silver. Because of their reserves, IamGold (IAG) and Kinross should recover and IAG is paying 4.9%. It has been rallying strongly from its depressed 2Q level. Both have strong quick ratios, IAG at 3 and KGC 1.9.
Also in precious metals and copper, note that FCX has rich reserves not only at Grasberg but in E&D in Serbia where it is 55-45% partner with Canadian junior Reservoir Minerals (OTCPK:RVRLF). The latter is an interesting play whose action does not correlate much with the sector. It will take some years but FCX is investing substantially there and there are plenty of strong Sovereign hands and major producers that will want that gold and copper. Junior miner McEwen (MUX) has enormous growth potential, is increasing production while reducing development costs at El Gallo II in Mexico by using heap-leach rather than vertical recovery. MUX remains debt-free.
If and when interest rates rise or spike, miners with heavy debt loads like ABX and NEM may have difficulty servicing LT debt whose yields could rise to 8% or more. Increased production and rising gold prices would then be necessary not simply nice. This is a reason to prefer PM miners with strong quick ratios like EGO, AG, GG, IAG, KGC, FCX, New Gold (NGD), MUX or Silver Standard (SSRI).
Many of the best plays now are in the PM sector. Epochal changes in the world reserve system and new forms of governance urge sheltering in strong hands in whatever sector you choose and retaining some liquidity, cash, short-term corporate bonds and bullion, the proportions depending on your means and inclination. If you believe social dislocation will not be radical, some numismatic coins graded by PCGS (Professional Coin Grading Society) or NGC (Numismatic Guaranty Corp) also are good asset.
Additional disclosure: I own precious metals companies and the S&P in diversified funds.