A Cypriot Black Swan
Eric Sprott is Chairman of the Board of Sprott, Inc., parent company of Sprott Asset Management USA, and has more than 35 years of experience in the investment industry. After becoming a chartered accountant, Mr. Sprott entered the investment industry as a research analyst at Merrill Lynch. In 1981, he founded Sprott Securities (now called Cormark Securities Inc.), which is one of Canada's largest independently owned securities firms. After establishing Sprott Asset Management in 2001 as a separate entity, Mr. Sprott divested his entire ownership of Sprott Securities to its employees.
Mr. Sprott has an impressive track record managing a range of funds, including the Sprott Hedge Fund LP, Sprott Hedge Fund LP II, Sprott Bull/Bear RSP Fund, Sprott Offshore Funds, Sprott Canadian Equity Fund, Sprott Energy Fund, and Sprott Managed Accounts. In 2007, Mr. Sprott was named Fund Manager of the Year by Investment Executive, a widely circulated publication for Canadian financial advisors.
I had the pleasure of recently speaking with Mr. Sprott by phone. The following is the transcript of the interview edited for readability.
Patrick MontesDeOca: Hello, Mr. Sprott and thank you once again for sharing your insights at this most opportune time. Getting right into the interview, first of all, can I have your opinion on a report you recently published on your website SprottUSA.com called "Markets at a Glance." In the report you cover in detail the Eurozone crisis currently happening in the Eurozone, Cyprus and many other peripheral countries. Can you give us your opinion and insight on that?
Eric Sprott: Sure. Well, Patrick great to talk to you again first of all and again congratulations for keeping people informed on events that are transpiring that perhaps aren't in the mainstream media but are important for people to follow very closely. The "Markets at a Glance" article I can probably explain in two words, and that is the title of the article: "Caveat Depositor." Obviously, when Mr. Diesel Boom suggested that there was no template, he was not being very forthright because there is a template. In fact, I think in his first interview he basically said the same thing four times. When the banks have risks, those banks' risks have to be shared with the various people who have liabilities with the firm, which are, of course, the depositors. We saw that play out in Cyprus and it was very, very unfair what happened. The more I think about it, and I don't think many people have commented on this, but what I find most interesting is that the depositors take the first hit. In other words, when the ECB (European Central Bank) says they are going to put in $10 billion-we are not even sure what they are going to put it in-they get a piece of paper in return. They say they have a loan to somebody and therefore it could possibly be repaid. The depositor walks away with a loss, day one. He doesn't get a piece of paper. In fact, I think I even heard that the ECB is exempting any deposits they might have as liabilities that they already had with Cyprus from the haircut. That is just a travesty of how things should work; the depositor taking the first hit. In fact the bigger they hit the depositor, the more likely the ECB is to collect their $10 billion, because of the hierarchy on the balance sheet. But essentially what we said is what we've seen in other countries, for example in New Zealand, where the banking authority just passed the same sort of thing. If there is a systemically important bank, here is what is going to happen, the same as happened in Cyprus. The government in Canada recently introduced legislation to do the same thing. The US and the UK have done the same thing. Obviously there has been a decision made by the governments who realize that their financial systems are at risk-their banking systems I should say-when their banking systems are at risk, how are we going to deal with this problem? Because the problems are bigger than the countries, because the banks are so much bigger than the countries, and that is obviously their solution.
PM: You know one of the things that I find disturbing is the complacency of investors in realizing that the central banks' leaders' intentions are to levy, basically to steal, deposits to save the banks. They do not really understand what the consequences are. Could Cyprus possibly be the black swan in the Eurozone banking system or will it disappear from the headlines?
ES: Well Patrick, for the first part of the question, that people are being benign about it, I'm not so sure in fact that is the case. We judge that by what's happening in the precious metals market and the stock market. The stock market is going up and the precious metals market is going down, and therefore everyone is complacent about it. I don't think that is the case whatsoever in the real world. As you know, the stock market is almost a function of central banks printing money, which is essentially what is happening. And I have written many times that I think the Western central banks continue to supply physical gold to the gold market to suppress the price, and I fully believe it and I fully documented it. The other thing I would say is that we have noticed that there has been a pickup in the buying of precious metals since the Cyprus thing happened. There is no doubt that it is happening when you look at US Mint statistics. We have a company called Sprott Money and we see more buying of gold and silver happening there. People aren't stupid, particularly when you realize that the people at risk are the people with over 100,000 Euros in the bank. These are not stupid people. These are people that got that kind of wealth because they anticipated things. I think that things are going on and I think it is a black swan. The thing I am watching the most is; what's the next bank? Because there are weak banks out there and we know who they are. Do we not think that there will be a bank run going on in some of those banks right now?
PM: Just the peripheral countries should be affected by this economically, so it's a domino reaction?
ES: There are weak banks in those countries. We all know who they are, so if you are sitting there with money in a weak bank do you think people are leaving their money there? I mean all they have to do is change banks-move it to at least a stronger bank.
PM: I think the danger is third-party risk at the highest level that you have ever seen.
ES: Right. You know the money has got to be moving and of course here is the problem; banks can't fund the deposit withdrawal because they don't have that much in current assets or cash ready assets, so when the money starts leaving, we have an example we had when Banco di Montepaschi said, We've had a few billion dollars, undefined by the way, leave the bank. You know you have to sell something in order to fund the deposit withdrawals, which means you have to sell an asset. In lots of cases banks don't have assets that are readily saleable, or the first ones to go, they sell and then of course it gets tougher. You can't just liquidate a mortgage portfolio, particularly when everyone else is trying to liquidate one. I would imagine that there are bank runs going on right now in some of these lower quality banks which you are not going to hear about, but you know it has to be happening.
PM: What does this mean for the fragile US economy and the stock market?
ES: I have always been of the view that there is no recovery. We are always told this is a great recovery, as we were told last year. We are told that 2012 is going to be a great year. We finally get to the end of the year and GDP is up .1%, so there was no recovery going on even as it was much touted earlier in the year. As I look at 2013, I've argued there is even more reason for there to be no recovery this year. We have had people who have taken a tax increase, we have had a sequester that is going to negatively affect people, and everyone is merrily looking at the stock market saying, "Oh well everything must be fine," but recent data is not very good. We've have the PMI's go down, and the purchasers manufactured index go down. We've had jobless claims going back up. We had announced job cuts up 30% in March in the United States this year versus last year. We had announced job hirings that went down by 90% this year in March versus last year. So my view is that it is not very robust at all. We've had lots of earnings warnings from Caterpillar, FedEx and Oracle, and restaurant chain sales went down 5.6% in February, which is totally in line with what would be happening to the disposable income of workers because of the increase in tax. So I don't think there is recovery. I think the market goes up on the fumes generated by the Fed, but sooner or later we are going to look at things in the light of day, what's really happening here, and I am very much looking forward to seeing the first quarter-both revenues and earnings-to see if this huge rally that we've had off the 2009 low is substantiated.
PM: You know, Eric, we have covered the Eurozone in our previous interviews and we talked about the possibility of bank runs and price controls. These are the very thing we are witnessing right now. Are we moving closer to a total collapse of the monetary system as we know it or do you think there is hope that things will get fixed?
ES: I think that we are getting closer to a total monetary collapse. If I took myself back 10 years, which we wrote about at the time, the problem is that the banks are too leveraged. They are all leveraged twenty and thirty to one. If you are leveraged thirty to one, you could take a 3% hit on your assets and you have no capital, well what the hell is a 3% hit. I mean if you are in Greek bonds or Cypriot bonds, you know what the percentages are; they are just unbelievably greater than that. That is the problem; the financial system got too leveraged. They got too leveraged, if you want to go back and review it, because the banks thought they could generate a 15% return on equity every year, and the banks as a group became such an important part of the economy. For example, I think at one point banking was 25% to 30% of the stock market. When you are 25% to 30% of the stock market, if you grow at 15% a year for about 15 years you are 100% of the stock market. It is impossible. How can you do that? But they believed it, and the only way they could grow that way is they had to keep leveraging. They just leveraged and leveraged in order to keep up this facade of being this wonderful business so that they could forever produce a 15% ROI while world GDP grew at 2 or 3%, so we know it couldn't continue to happen.
PM: What are the alternatives to deleveraging or what is the process?
ES: Well there are only two ways to deal with it; either you inflate the debts away through hyperinflation…
ES: …which is one way of doing it. Of course the other way is what you call a dead jubilee or where you all just agree, we can't pay off these debts, let's just write them all off, which of course would be disastrous for those who think they have some asset which is worth something in their portfolio and find out that they aren't going to get repaid.
PM: Well isn't that happening right now in Cyprus?
ES: That's exactly what's happening in Cyprus, and already happened in Greece. I mean that was a $100 billion haircut there, and it'll happen in other countries. You know it's funny that almost every month these European countries keep downgrading their GDP growth and upgrading what the size of their debt or deficit is going to be versus GDP; every month it goes higher. I have a theory that weakness begets weakness. When JP Morgan announced they were going to lay off 19,000 people, it's not just the 19,000 people that are affected. It is where the 19,000 people spend their money, they are also affected. There are only two ways to change a trend of weakness: fiscal policy and monetary policy, and it has got to be sort of an exogenous event. Nobody has got any room for fiscal policy changes. Here we even have austerity in the USA with sequestration. Everything is austerity policies in Europe, so we don't have a fiscal policy that can change things. Now you go to monetary policy. We have zero interest rates and we are printing money. Is there anything left in the tank here? I don't think there is anything left in the tank.
PM: There is some discussion going around about basically using gold as collateral to replace austerity in the Eurozone and some other countries. How much of a real possibility is that, that they could use their gold reserves?
ES: In other words sell the reserves to spend more money?
PM: Not sell it, but basically collateralize it lets say five to one in order to possibly generate some liquidity and reduce the interest rate payments on the bonds.
ES: I don't know who would want to be the guy backing that quite frankly. Maybe the ECB would. It's just another form of printing money. They may as well print the money.
PM: Well, that's essentially the same thing.
ES: Have another LTRO (Long Term Refinancing Operation) right? Whatever amount of money you want, just take it. But all of these are essentially insane financial policies. It comes down to pure insanity. We keep thinking and looking at the same things they do and they don't work. We keep thinking the next one is going to work. QE1 didn't work. QE2 didn't work. It doesn't look like QE3 is going to work. I don't know why people are always hopeful something is going to change the economy. It just doesn't have any spunk to it. The only things that are getting better are auto sales and home sales, which are 100 percent reliant on ridiculous amounts of credit. Particularly in autos, I was reading in an article where subprime lending in autos has gone crazy. So we keep having these people who can't afford a car, get a car. Of course the interest rate is 25%. Then they put it in some package where they sell it off as a lump sum. It's almost like subprime in housing all over again.
PM: Moving into the gold and silver market, Eric, what's going on with the gold market? Have you ever seen such a disparity between the paper and the physical market in your career?
ES: It gets a little more bizarre all the time and I'll just use one proximate. Look at US mint sales. They're up 40% in gold and 40% in silver, which is a statement about what people think of the system. Here we have the price of gold going down, which unfortunately is determined in the paper market, so there's no decrease in demand for gold and silver here. But I think there are so many reasons for the Western central banks to want the price of gold to be down, because it would be the towel on their financial policies and they know it. We're all looking at inflation to break out with all the printing of money. Where are you going to look for inflation first? You think it would be manifested first in gold and silver because that would be the first physical thing that people would buy because it is so easy to store and it has a long history. We're not all going to go out and buy wheat and soybeans and stuff like that. The natural thing to do is to go out and buy gold and silver, and I see by the US Mint statistics that that's what people are doing; they are buying it.
PM: Just for the common listener to understand; why is the price of metals going down if there is physical demand like you describe?
ES: Because the Comex market, which is a paper market, determines the price. For example, I believe that if I single handedly wanted to go into the wheat market today and sell a bunch of wheat contracts, I could probably get the price down 5 percent today in the paper market. God forbid they ask me to deliver the wheat because I wouldn't have it. But that's what is going on. People are shorting the paper market and driving the price down. I think it's the big banks that were short or scaring the hedge funds into thinking gold and silver are going to go down. They all start shorting it. All the while the big bankers have been short the whole time and covering their shorts, and now we've got all the hedge funds going short.
PM: The commitment of traders report showed that the specs increased their short position to a massive 22,382 contracts from about 2,900 as of February 5. That is huge.
ES: That's what's happening. You get everyone believing it's going down and you get these reports of this, and others who have never been right on gold suggesting that the gold price is dead or that the market's over and everyone, herd like, goes into shorting the paper. They're going to get a rude awakening when we find out that China is still a buyer and Russia is a buyer and Turkey is a buyer and all these countries that have been buying gold, they're not going to back away from the gold market. It's like it's on sale here. The physical guys will win the day here.
PM: What other metals do you like besides gold and silver?
ES: Well, Patrick, we just started a platinum and palladium trust the same as our silver and gold trust. When we look at the supply/demand for platinum and palladium it's just outstandingly positive. We even had Russia and South Africa talking about having a cartel in the metals, and the price didn't do anything. They want to get together and do something. They produce 80 percent of the world's platinum and palladium, so that will have a big impact. But again we had all these people coming in to short those two markets, too. Where there was no activity in the futures markets, all of a sudden there's these huge short positions in platinum and palladium. I think they went in there because of the shortage of platinum and palladium. The outlook is so positive, but they didn't want them to go because it might lean into silver and gold. People see that platinum might go through $2,000 (an ounce). People are going to buy gold, too. So they try to control these things and they control it because they know any central banker in his right mind must know that those policies are insane and irresponsible. They know it. And yet we've got to keep everyone in the game and keep them calm and keep the market going up; keep gold a little subdued and everything looks normal. Cyprus is a one-off event. Oh yeah! Sure it is. It'll be a one-off event until we get the next event.
PM: What do you think of the mining sector, Eric? They've demolished that completely almost to the point of extinction, but what do you make of it?
ES: Well, you know there are some tremendous opportunities in mining. I'm looking now at some companies that could pay very, very significant dividends. I'm talking about dividends of 20% per share. One of the things we have got to convince some of these managements is that if you pay the dividend and don't start the new project, your shares will react. As long as you've got a long life line, just pay the dividend. Your share price will probably double and it'll still be yielding 10%. You'll be able to raise all the money you want for your future capex (capital expenditure) program. But, whatever you do, don't commit to another project, because then the investors will say, I won't see that money for a while and now I gotta worry about the next mine and is it going to be capex or is the mine going to work? You put all this risk on the table that's not necessary, because mining companies are quite profitable and they have a lot of free cash flow, so they could easily pay it out. I'm working on trying to get some of these companies to go that route and I suspect we're going to be successful.
PM: Eric, can you leave our audience with your wisdom and insight on how to deal with these unfolding and accelerating crises?
ES: Sure. I think the safest thing I can say is that paper assets are very dangerous to own. I wouldn't be caught dead with a Japanese bond or a US bond or a UK bond or an ECB bond. First of all, you get paid nothing. Much like a bank deposit, you get paid nothing. Now you find out your risk, as it is in Cyprus, was 60%. My god, you get paid nothing while taking on all that risk. As I've written many times before, the US is effectively bankrupt. The gap deficit was $6.6 trillion last January, excepting accounting principles. The deficit was $6.6 trillion, as was announced by the Department of the Treasury. That news never made it to any newspaper by the way, but that is what they announced, and this year it will be $7 to $8 trillion. This is all in a $16 trillion economy. There is no way they are going to meet their entitlements, so you just give yourself a little forward time here; it might happen in as little as one or two or three years. This whole paper thing could just implode in front of us, so I think get out of paper and get into real.
PM: For the benefit of our audience, Eric, how can they get in touch with you, and learn more about your product?
ES: Well, as you know Patrick, we have the gold and silver trust, and now the platinum and palladium trust listed on the NYSE and in Toronto here. People who want to keep up to date on the things we write, if they just send a note to Sprott.com, we'll put them on our mailing list and they can see the array of hedge funds and other funds we run here.
I think that one thing we bring to the table is that we bring a view that isn't an accepted view; it's always a little off the scale. It has been important to be off the scale in these last few years because we've gone through some pretty weird times that most people would never forecast, so if they go to Sprott.com they'll know everything they need to know.
PM: Once again, Eric, thank you for your time and your insight and wisdom, and until next time my friend, you take care.
ES: OK, Patrick all the best to you now.
The information in the Market Commentaries was obtained from sources believed to be reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed therein constitutes a solicitation of the purchase or sale of any futures or options contracts.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AG, GDX, GLD, PSLV, AGQ, DBS, DSLV, PSLV, SIVR, SLV, USLV, USV, ZSL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The information in the Market Commentaries was obtained from sources believed to be reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed therein constitutes a solicitation of the purchase or sale of any futures or options contracts.