Ryan Darwish of Eugene, Ore.-based Darwish Capital Management is a CFP and RIA and has been in the industry as an investment manager and financial planner for more than 20 years.
Which single asset class are you most bullish (or bearish) about in the coming year? What ETF position would you choose to best capture that?
In my analysis, precious metals would be the asset class I am most bullish about for the coming year. The ETF position I find most attractive to best capture the potential return is Market Vectors Gold Miners ETF (GDX).
How does this ETF fit into your overall investment approach?
My overall investment approach is laid out in my book, The Emperor’s Clothes: Megatrends Affecting Your Financial and Investment Decisions. My view is that consideration of global political and economic events are critical in coming to sound financial and investment decisions. These factors are what create the structural context for the investment environment.
Tell us about the sector. What makes this your top pick?
One of the basic functions of money is as a store of value. If the viability of this function becomes impaired, it is important to consider where economic value will be best preserved, or even increased. When making investment decisions, the objective is, at a minimum, to preserve value - and if we choose wisely, to increase the real value of our net worth. Implicit in the idea of value is what preserves and increases our purchasing power.
Because of the privileged position the U.S. dollar has held as the reserve currency of the world, the mystique of power and safety has become an assumed fact in the perception of most financial players. In my opinion, it would be an error of judgment to assume that the United States has been divinely exempted from the laws of economics, or that the dollar has any value other than a faith-based presumption of economic entitlement.
There is a growing awareness that a fundamental structural shift has occurred, or is in the process of occurring, in the power arrangement of the global economy. Events of recent years should have served as a wake-up call that placing blind faith in institutions such as investment banks, banks, insurance companies and governments is likely to be hazardous to an investor’s financial health. One thing that should be abundantly clear is that financial imprudence at all levels of our society, and throughout the world, has became institutionalized into an acceptable form of conduct. Imprudent lending, and imprudent borrowing, has created a vicious destructive cycle of over-consumption and over-indebtedness. As with many extreme indulgences, when the party is over, we are left with a big hangover and a big cleanup job. Right now the United States in particular - and the world economy in general - has one gigantic hangover, and a daunting clean up job.
With a $1 trillion-plus budget deficit, the United States will likely need to borrow over $70 billion per month from foreign sources in order to continue funding its operations. The question that must be asked now is: How willing and how able will these foreign funding sources be to continue loaning money to the United States to fund its budget deficit? Many of these countries are having a more difficult financial time themselves. Many of these countries were, prior to this financial turbulence, considering reducing the amount of money being loaned to the U.S. In addition, because of the crisis the creditworthiness of the United States has deteriorated, and there are alternative places where these countries can deploy their financial resources which may be more directly beneficial to themselves. The conclusion is inescapable that a potential funding crisis will be one of the major consequences of the current attempt to contain this financial crisis.
Governments of the world have made massive commitments toward maintaining financial and economic stability. On a global scale, trillions of dollars have been committed to financial and economic stabilization. Each time a government responds to a financial crisis in an industry, business, another sovereign county, or municipality, the financial hole gets deeper.
What are the bigger threats?
Looking forward to what pending financial crises of global significance crises are likely to emerge, there is no shortage of candidates. On the front burner is the unfolding European financial meltdown. A prudent view would be to assume that as bad as it looks, it is likely to be much worse when one factors in the amplification effect of derivative positions likely held by systemically important institutions. On the back burners, waiting for their chance to emerge are the rapidly deteriorating conditions of the pension systems, the FDIC, as well as state and local municipalities.
The biggest player is the U.S. Government itself. The $1 trillion-plus budget deficit projected indefinitely into the future does not even take into consideration expensive contingencies which seem to inevitably arise, such as natural and manmade disasters, wars, and other Black Swan events which will necessitate additional funding requirements. How will all the unfunded liabilities and current operating expenses be paid for? One might argue that incurring these expenses is necessary, but there are also consequences.
That there will be increasing insolvency, massive economic displacement, and economic restructuring is appearing to be more and more a given. We are at a global economic watershed point. A recent book, This Time Is Different, by two eminent economists, professors Carmen Reinhart and Kenneth Rogoff, is based upon a compilation and analysis of data looking at government’s financial behavior over the past 800 years. Among their conclusions is a pattern which emerges as a constant. Governments overspend, overborrow, and then default. The two basic methods of default are an outright refusal to pay their debts, or an implicit default. In an implicit default the intent is to debase the currency with the objective of repaying existing indebtedness with a lower value currency, in effect, an attempt to inflate away the real value of a currency.
Given the current operating deficits, as well as future liabilities, the United States is on a trajectory that is financially unsustainable. Considering the position of the U.S. dollar as the reserve currency of the world, the question of default must be addressed by an investor who considers that somehow events occurring in the world matter to the investing results achieved. In my view, an outright default by the United States of its debt is a probability so small as to be insignificant. On the other hand, an implicit default, where the United States attempts to inflate its way out of its financial hole is extremely likely, especially when there is no limit as to how much money the government can create.
What will that mean for allocations?
If we assume, for purposes of discussion, that this is the direction in which economic history will move, it becomes useful to consider some of the implications of this scenario for asset deployment purposes. While there is a great deal of discussion regarding the demise of the U.S. dollar, it is often followed by consideration of other currencies as a safe harbor refuge. This may be a false sense of security. One of the reasons for the U.S. dollar's problem is the lack of monetary discipline because of the fiat nature of the currency; the same problem exists with other currencies. There appears to be an inherent instability with a fiat monetary system. Consequently, in my opinion, it is a mistake to believe that other currencies might be anything other than a temporary refuge.
It is the consequences that follow which will provide both the hazards and the long-term opportunities, from an investment and financial planning perspective. It is exactly here that both the risks and the opportunities reside. In my estimation, the outcome of these circumstances will result in escalating interest rates, which is another version of credit availability reduction, and a damper on economic growth. This would be an unacceptable outcome for our government, whose interests are critically tied to economic growth. The policy response will be an attempt to create vast amounts of money in order to effectively devalue debt, and consequently the dollar.
Current economic policy discussion focuses on a debate as to whether we are looking at a deflationary or inflationary future. In my opinion, while I harbor the view that we will experience a severe hyperinflationary and stagnant economic future, I consider this to be somewhat of a secondary consideration. A primary consideration, which will continue to shape investor behavior, will be the economic uncertainty and dislocation which arises, whether the future is inflationary or deflationary. This economic instability is already creating a greater shift in the view of what is perceived as a more desirable asset class to act as a reserve of reservoir of economic value.
Considering assets which might best retain or increase in value: Current market behavior suggests there is growing recognition that investors have started voting with their feet. One investment area which has highlighted these opportunities is precious metals, in particular gold. The evidence, from reports of shortages of gold coins to the increase in bullion reserves by central banks such as China, India, Russia and Saudi Arabia, makes a compelling case that we are not witnessing merely a speculative thrust at a trading position, but rather a sustainable shift in perception of an asset that will withstand the rigors of the economic storms we are facing.
In these interviews when gold comes up, we've been talking about whether the inverse relationship between the dollar and gold prices holds up in today's market. So do you share the opinion that investing in gold producers is a good deal regardless of a deflationary cycle?
Yes, I do. Whether we are in an inflationary or deflationary cycle is only one factor. In my mind, we are entering a period where questions of systemic solvency will weigh more heavily on investor sentiment and the search for a "safe harbor."
Are there alternative ETFs that could be used to capture the same theme? What makes this specific ETF your first choice?
Aside from owning gold directly, there are now opportunities with ETFs such as SPDR Gold Trust (GLD), to take positions that very much mimic the economic characteristics expected of a currency. In my analysis, this provides a compelling reason to expect the demand for gold to continue to increase. It follows that if one expects the demand for gold to increase, those entities which hold reserves of gold, as well as the productive capacity to bring it to market, can be expected to be beneficiaries of these circumstances. It is from that perspective that if I had to choose only one investment, I would select GDX, an ETF of gold miners as my investment of choice. As an additional factor, it has a lower than category average expense ratio and turnover which I also find attractive.
One thing that leads some to invest in the miners rather than bullion ETFs is a concern about market manipulation, or that there's not enough physical gold behind the bullion ETFs' market cap; does that at all inform your choice of producers over investing in the metal itself?
While I'm aware of this concern, it is not really a major concern of mine with regard to this choice. A bigger factor is the leverage gained from having producers with proven reserves, of an asset for which demand is growing due to conditions that are likely to persist, at the very least.
How does your view differ (if at all) from the consensus sentiment on the sector?
While there are always mixed opinions on investment positions, with observation of the behavior of precious metals pricing, one cannot help but come to the conclusion of a growing bullish sentiment. I would not say there is a current consensus. However, the reports of very large positions in gold being taken by large hedge funds certainly suggest that knowledgeable and sophisticated investors are increasingly recognizing the importance of this asset class.
What catalysts, near-term or long-term, could move the sector significantly?
We live in a world of extreme uncertainty and instability. Anything which affects these conditions can and will move this sector. War, a terrorist attack, a natural disaster such as hurricanes, earthquakes, or erupting volcanoes - or for that matter if some miraculous breakout of peace, or a rash of prudent economic policy decision-making were to occur, one could expect to see this reflected in precious metals pricing.
One should be clear about what one’s reasons are for taking a position in this ETF. Taking a position for trading purposes would lead one to take into consideration sentiment factors that are very fluid, whereas taking a position as a core part of one’s assets would call for an investor to try to sort out market “noise” from a compelling structural analysis of attractive investment conditions.
What could go wrong with your pick?
One thing I have learned from over 20 years of investment decision making, and corroborated during the experiences of my younger years working in research laboratories, is that no matter how well thought out and rational a position is, it does not necessarily mean that is what is. As a consequence, it is important to examine and identify where the potential risks lie in our expectations. The year 2008 gives provides us with a great opportunity to examine what happened to gold during that time of extreme financial duress.
Deleveraging caused massive indiscriminate selling pressure. Institutions were forced to raise capital to meet their regulatory requirements. At the same time the credit markets froze up, making capital very difficult to acquire. This made the situation even worse. Hedge funds are investments for institutions and very wealthy individuals. They operate by borrowing huge amounts of money using their invested positions of stocks, bonds, and the more esoteric derivative investments as collateral. Some of these funds borrow 30-40 times the amount of actual dollars directly invested in them by their investors. The lenders who provide this money to the hedge funds have lending requirements which require the hedge funds to come up with more money if the value of their investments drops too much.
During the financial turmoil, the decline of the investments in these hedge funds forced the hedge fund managers to start selling their investments whether they considered them good investments or not. This amplified the overall selling pressure and made a bad situation even worse. It did not matter whether an investment had merit or not, it was going down, and gold did likewise. It is certainly possible for this to occur again. It should also be noted that GDX seems to trade more like a stock than GLD, hence one might expect higher volatility. One of the only assets which did well in 2008 in comparison was U.S. Treasury debt, due to the perception of safety.
If we fast forward to the emerging European crisis of 2010 and examine market conditions, we can see growing investor perception recognizing gold as a safe harbor. Additionally, the gut reaction of flocking to the U.S. dollar as a safe harbor seems to be becoming somewhat more muted. In my view, I see this as a growing trend that will greatly benefit GDX over time. By the same token, does this suggest to me that it would be appropriate to bet the family farm on this position? Absolutely not! Even if an investor sees merit in my analysis, each individual investor needs to evaluate his own risk tolerance and circumstances to arrive at an appropriate allocation to GDX even if it is the only investment position they are taking.
Thanks, Ryan, for sharing your thesis with us.
Disclosure: Long GDX
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