Gold and Energy Advisor: Gold, Oil & Energy Markets Investment Research
James DiGeorgia, Mr. Macro
- Chief Editor -
Mr. Macro
Geoff Garbacz, Mr. Micro
- Chief Strategist -
Mr. Micro
Dan Hassey, Mr. Retirement
- Senior Stock Analyst -
Mr. Retirement

Newsletter #122  05/01/2013



“Gold Prices Plunge! What Does This Mean For Its Future?”

“The yellow metal is down 24 percent from its highs. Is this the end of the gold bull? Or is it a temporary correction?

“I believe it’s temporary! In fact, I expect to see huge amounts of capital flowing back into gold, taking the prices far above their previous highs. Here’s why!”

We’re only 4 months into 2013, and we’ve already had a series of historic financial crises.

Investors have been bloodied in multiple markets. And the battering hasn’t yet run its course.

For maximum success in our investing, we need to anticipate the strongest trends, and get in front of them. Right now, one of the largest global trends is...

Fear!

Investors are scared, and rightly so. Even the assets that used to be safe are risky now.

Nevertheless, wherever there is danger, there is also opportunity. When oceans of capital move from market to market, there are big winners and big losers. If we want to flourish as investors, we need to follow the money. We must anticipate where it’s going, and get there first. That’s when tremendous profits can be made.

Right now, the world is awash in liquidity that’s flowing from one asset to another. The markets are scared and confused. That’s why we’re seeing such truly bizarre events, like a crash in the price of gold even as global central banks have printed almost $17 trillion (!) in new money.

But such confusion is temporary. Eventually things will stabilize, and I believe it’s possible to see where things are headed—and get positioned for big profits.

More on that later. Let’s start by discussing why there’s so much turmoil today.

Investors are scared because many of the assets that are usually safe have turned dangerous. This includes some of the largest markets in the world, such as...

The Bond Market

In the January and February GEA issues, I wrote about multiple threats to bonds.

These are debt instruments, so they’re priced inversely to interest rates. Back when interest rates were on a long decline, and rates fell to historic lows, the bond market was a fountain of cash. This bull market lasted for a remarkably long time.

Today, with rates at rock bottom, they can hardly be expected to go lower. There’s only one direction where large rate moves are possible—up.

And that means bonds have little possible reward today, but an enormous amount of risk.

This is true across the market. Even the sectors that historically have been safe are dangerous now, including…

Government Bonds

There are two ways to look at government bonds today:

  1. When you buy a government bond, you’re buying one of the safest assets possible. You’ll make only a small return—if you make anything at all—but at least you’ll get your money back when the bond matures.
  2. When you buy a government bond, you’re lending money to the “ineptocrats” who run that government, and who love to devalue their own currency. Yes, you’ll get your money back—eventually—but it will be worth a lot less by that time.

When investor opinion swings between these two perspectives, large amounts of cash can move in or out of bonds.

With Western governments running their currency printing presses at full speed today, the second perspective has become very compelling.

As a result, investors are starting to shun government bonds.

Demand for certain types of bonds has all but dried up. The Federal Reserve is currently buying about three-quarters of US Treasury and mortgage-backed securities, to prop up the market.

This is partly because the Fed wants to inject lots of liquidity into the economy. But it’s also because US Treasuries and mortgage-backed securities are real stinkers at the rates that are being offered.

Again, this shows that the market has a lot of risk, with low potential rewards.

And speaking of stinkers, that brings up...

Local Government Bonds

In the United States, states and local authorities (for example, counties and municipalities) also issue bonds.

Historically, these have been thought of as safe investments. In reality, they can be quite risky. Many investors have learned this the hard way, as in the 1994 $1.5 billion bankruptcy of Orange County, California. More recently, in 2011 Jefferson County in Alabama also went bankrupt. Investors got shellacked for $4.2 billion.

Now some analysts are warning that bankruptcies like these were just previews of bigger implosions that are coming.

A few weeks ago, the Wall Street Journal ran an article called “The Debt Bomb that Taxpayers Won’t See Coming.” It warned that many local governments are wallowing in unsustainable debt, but are deceiving investors and taxpayers about their financial condition.

Examples included:

  • The state of Illinois, whose officials were recently charged by the Security and Exchange Commission for covering up the near-bankrupt condition of the state pension fund.
  • The city of Sacramento, California, which has accumulated $2 billion in obligations, in a municipality with only 477,000 residents.
  • Numerous “independent borrowing authorities,” created by local governments to borrow vast amounts of money while preventing taxpayers from voting on the borrowing—like New Jersey’s “School Construction Corp.”, which borrowed a staggering $12.5 billion for refurbishing school buildings (and then squandered over $4 billion of it on “patronage and inefficient constructions practices”).

The article reported that many local governments are in dire financial condition:

“According to studies by the Pew Center on the States, states and the biggest cities have made nearly three-quarters of a trillion dollars in promises to pay for retiree health-care insurance. Yet governments have set aside only about 5% of the money they’ll need to pay for these promises...

“A December report by the States Project, a joint venture of Harvard’s Institute of Politics and the University of Pennsylvania’s Fels Institute of Government, estimated that state and local governments now owe in sum a staggering $7.3 trillion. Incredibly, the vast majority of this debt has never been approved by taxpayers, who are often unaware of the extent of their obligations.”

Obviously, these problems are not new. It takes many years (and a spectacular amount of corruption and incompetence) to build up boondoggles like this.

What is new is that the governments are failing in their efforts to cover everything up. What was once hidden is now becoming known.

Once it does, the bottom will fall out of this market.

Other Reasons to Avoid Bonds

Distrust of government finances is an excellent reason to avoid the bond market today, but it’s not the only one.

Investors also perceive a skyrocketing risk of inflation, thanks to the trillions of dollars created by the Federal Reserve. Buying bonds at today’s low rates could be a quick, easy way to lose lots of money.

Also, thanks to the low rates, bonds have meager returns. Fixed-income investors in particular need higher returns than the pittances available from most bonds.

Lastly, there’s the currency issue I raised earlier. One of the main selling points of bonds—their safety—is degraded when there’s erosion of the underlying currency.

It’s much less attractive to be guaranteed a future return of your money, when that money might have turned into toilet paper by the time you get it back.

Which brings up our next topic...

Dangerous Currencies

The global currency market is gargantuan, with an estimated $4 trillion of daily turnover.

To be clear, most of this activity isn’t from investors. Most of the turnover is made up of traders jumping in and out of the market, trying to take profits on small ticks. Nevertheless, there’s still a tremendous amount of capital invested in currencies over longer time periods.

And here again we see a market with a tremendous amount of risk.

Imagine that you were a currency investor or broker, and you were responsible for finding a good home for billions of dollars in capital. Where would you put it?

Let’s assume that you’re supposed to stick with the major currencies of the world. (Smaller currencies can be good values, but they’re harder to assess, and they’re far less liquid than the majors.)

So, you’re supposed to choose from among the “big three”: the dollar, yen, and euro. Which would you pick?

Don’t Pick the Yen

Japan has been in a depressionary slump for over 20 years. Previous ‘stimulus’ programs—and there have been plenty of these—still haven’t pulled the economy out of its rut.

Japan basically invented Quantitative Easing (the same policy currently being pursued by the Federal Reserve). Unfortunately, it hasn’t worked.

Despite undergoing no less than eight rounds of QE, Japan frequently falls back into recession and deflation.

So far, the only long-lasting effect of Japanese QE is a mountain of accumulated debt (about 20 percent of GDP just from QE programs alone).

Despite QE’s lack of success, Japanese officials have decided that it’s not QE’s fault. No, it’s been the fault of timid officials who haven’t pursued QE aggressively enough.

Japan’s leaders still believe that if they can devalue the yen enough, the Japanese economy will revive. That’s why in January they launched a massive stimulus program of 10.3 trillion yen.

That’s the equivalent of 2.6 percent of GDP all by itself. As Japan’s Prime Minister commented, this was intervention “on a different scale from previous measures.”

But even that didn’t work.

So now Japan’s leaders are deploying the big guns. A few weeks ago, Japan announced a plan that Reuters referred to as a “radical gamble” and “the world’s most intense burst of monetary stimulus.”

During this massive two-year intervention...

Japan will double its monetary base!

It’s hard to imagine a more open and deliberate attempt to destroy a currency than this.

And it’s working. The yen is getting crushed, falling 20 percent against the dollar in just four months.

This is great news for Japanese exporters. A weaker yen means that Japan’s exported goods are far cheaper for other nations to buy.

But it’s terrible news for other exporting nations who compete with Japan—especially with a weak global economy, where there’s a shrinking amount of demand to fight over.

So, most of Japan’s neighbors in Asia are busily preparing their own interventions. And this raises the frightening possibility of a large-scale currency war—a competition to devalue one’s own currency more than your neighbors can devalue theirs.

As I’ve warned before, a currency war is very dangerous. Even though it starts between two or three nations, it doesn’t take long before everybody else gets sucked in too.

Japan is starting a “race to the bottom” that could wipe out currency values all over the world. As the American Enterprise Institute recently warned, “Currency wars in Asia may be the world’s most intense.”

The damage this will do is still unknown, but one thing is already clear. The yen is a terrible investment right now.

So, the first answer to “Which one would you pick?” is this: “Do not pick the yen.”

The second answer is...

Don’t Pick the Euro Either

As the saying goes, hindsight is always 20/20.

When the euro was first established in the 1992 Maastricht Treaty, conventional opinion was that it was a brilliant idea.

If you disagreed, you were called a fool.

Today, things are very different. Now it seems obvious that the euro has potentially fatal contradictions in its very foundation.

Every Eurozone member must use the euro as its sole currency. There are currently 17 member states that do this.

This could work well if all the member economies were similar. But they’re not.

Let’s take two Eurozone members—Germany and Greece—as contrasting examples. The Germans exchanged a strong currency (the mark) for a weaker one (the euro). Thus, their exports are priced in a weaker currency than before. This makes their goods more competitive, so German exporters have flourished under the euro.

For Greece, the opposite is true. They exchanged a weak currency (the drachma) for the stronger euro. Among other things, this has crippled their ability to export goods and services.

Unsurprisingly, this has taken a heavy toll on the Greek economy (which wasn’t all that strong anyway). Even worse, as it has crumbled, the euro has locked it into its downward spiral.

When a nation’s economy weakens, that nation’s leaders usually loosen monetary policy to revive it (as Japan is trying to do). But Greek leaders can’t do this. They can’t loosen the Eurozone’s monetary policy on their own, and the other Eurozone members are unwilling to risk overheating their own economies just to help Greece.

So the euro is slowly squeezing the life out of Greece, along with the other weak Eurozone economies. These nations trapped themselves in a no-win, no-escape situation back when they adopted the euro and ‘married’ the powerhouse economies of Northern Europe.

Now things are moving to their logical conclusion.

In Greece, as the economy shrank, the government in Athens tried to prop it up by borrowing huge amounts of money—mostly through selling bonds to European banks.

Even as Greek debt grew to monstrous levels, European banks continued to buy it at low interest rates. (After all, Greece was part of the big happy Eurozone, so its finances must be stable.) So the debt bubble inflated more and more.

This lasted far longer than it should have, thanks to corrupt Greek officials who concealed the growing disaster. But the cover-up couldn’t last forever—and it didn’t.

When the truth finally came out, it was explosive. Greek bonds have blown up, and...

European banks that own the bonds are (still) at risk of melting down.

As I’ve discussed previously in GEA, the largest banks in Europe—some of the world’s biggest financial institutions—still hold large amounts of Greek debt that has gone toxic. Some of these banks would be bankrupt already, if they were forced to correctly value these bonds on their books.

Ultimately, toxic Greek bonds could destroy the entire European banking system. And the collapse of Greece is only a sideshow compared to the much bigger catastrophes building in Spain and (especially) Italy—nations that also have sold mountains of bonds to large financial institutions in Europe and elsewhere.

And as if that weren’t enough, the ongoing fiasco in Eurozone member Cyprus has even called into question the stability of Eurobank cash accounts.

Cyprus first plunged into recession in 2009, and recently started accelerating toward full-blown collapse. To avoid this, other Eurozone members reluctantly agreed to a bailout, but they required the Cypriot government to cough up a lot of the funding—which it didn’t have.

To get the cash, Cyprus is now closing its second-largest bank, and stealing—excuse me, levying—all its uninsured bank deposits. In addition to this, some 40 percent of uninsured deposits in Cyprus’ largest bank are being stolen—excuse me, levied—as well.

Many are claiming that this plan is fair, especially because an earlier plan involved shaking down all depositors, not just those with large uninsured accounts. But theft is theft, regardless of whether or not the victim could (possibly) afford it.

The Cyprus confiscation has rattled the confidence of depositors across Europe. A bank account used to be one of the most conservative places to store your money. Suddenly it’s become one of the easiest ways for a government to take your money away from you.

Yes, all the Eurozone governments are making soothing noises about how this situation is unique. (Every situation is always unique.) And they would never take such an extreme measure again. (Until they do.)

If there’s any lesson to glean here, it’s this: do not store your money in European banks, whether in weaker countries (where accounts are now liable to be raided for bailouts) or in stronger ones (which have insisted on the raids being done elsewhere in the Eurozone, and thus have created a precedent for it happening in their own nations as well).

It seems safe to say that there will be a mass exodus of capital out of Europe. As a report in The Guardian commented:

“Occasionally, financial reporters face brickbats for stories that may trigger a bank run; but this is the first time I have seen a policy that could almost be designed to spark one.”

Not only that, the legitimacy of the entire Eurozone is now in question. Again quoting from The Guardian:

“A friend of mine has a mid-level job at the European Commission. Over the past few years, through Greece and Ireland and Portugal and Spain, he has kept up a resolutely chipper air. This weekend, as details of the Cyprus deal came out, he sent me this email: ‘Is this what the European financial system has come down to? A direct appropriation of savings because it cannot cure its systemic problems. It is not just the banks that are bankrupt. It is the whole bloody model that has run its course and we are in denial’.”

The euro’s future looks grim. Even before Cyprus, there were already strong incentives for countries to bail out of the common currency. The latest events only add to the chaos and uncertainty.

But one thing is clear. Anything connected to the euro is not a good investment.

And that’s why...

The Dollar Has Benefited—For Now

Even before the latest crisis erupted in Europe, investors were already selling euros and buying dollars.

As low as American interest rates have been, they’re still up to one-fourth higher than comparable European rates, thanks to Eurozone officials who have tried to rescue their failing system by driving rates down.

Now that Greece and Cyprus have imploded, and Spain is on its way, and Italy is threatening an even worse catastrophe in the future, capital is fleeing Europe outright. It’s running to the dollar as a safe haven.

But this is a short-term reaction, not a long-term trend. Yes, the dollar’s long-term prospects are much better than the euro, but that’s not saying much.

In some ways, the dollar resembles the yen. The Fed is still creating $85 billion per month in its QE3 program. Meanwhile, the US government is racking up about $3 billion in new debt every single day.

Most of the Fed’s new money is still bottled up in the banking system. The banks aren’t lending it out—yet. But once they do, hundreds of billions of dollars could flood into the economy in a very short time.

The dollar is horribly vulnerable here. Right now, it’s benefiting as a safe haven from the ongoing disasters in Europe and elsewhere.

But it’s not a good long-term asset, and investors know it.

So where will investors go?

All the markets I’ve discussed contain huge amounts of capital, but they’re becoming very dangerous.

So where will the money go?

There are two likely beneficiaries of the ongoing turmoil. The first is the US stock market.

This doesn’t mean that stocks overall will be good investments. Our economy is still struggling to keep its head above water, and corporate earnings will reflect this.

But incoming capital will seek out the best stocks, and these should do very well. In particular, the most promising energy stocks should benefit both from global capital flows and the inherent bull market in energy.

The growing shortage of cheap oil doesn’t get much coverage in national news anymore. Gas has been in the $3-$4 range for a while now, and the talking heads in the media tend to focus on whatever is new and shiny.

Nevertheless, the shortage is real. (I devoted the entire March issue to this topic.)

So I expect energy stocks to be strong performers in the years to come. In addition to the underlying fundamentals of oil, they’ll also be the first beneficiary of the current global turmoil.

The second beneficiary is...

Gold!

Yes, the same commodity that’s been getting pounded lately.

It’s no exaggeration to say that the yellow metal has taken a real beating. It’s down 24 percent from its highs.

This isn’t surprising. (I’ve been writing about this in my Updates for some time.) A correction was due.

It’s also great news for gold buyers.

Here’s why. I believe gold is still in a strong long-term bull. And in a long-term bull, large corrections are both inevitable and beneficial.

Without large corrections, this wouldn’t be a bull market. Instead, it would be a bubble, which would be temporary and unsustainable.

But a bull market it is, for two reasons: supply and demand. Let’s discuss these, starting with...

Booming Gold Demand

If gold’s recent price drop was part of a long-term trend, we would expect demand to be sagging.

But that’s not the case.

The US Mint has just halted sales of its one-tenth ounce US Gold Eagle coins. Why? Because demand has overwhelmed supply, and the Mint ran out of gold blanks. This is the first time it has stopped selling a gold product since November 2009.

Demand is surging around the world. Britain’s Royal Mint just announced that its gold sales tripled year-on-year, leaping up 150 percent just in the last month. The Mint’s director of bullion and commemorative coin said the increased demand came from across the major coin markets, and “shows no sign of abating.”

This isn’t just a short-term spike from bargain-hunters. Gold demand has been consistent and tenacious.

According to the most recent figures from the World Gold Council, gold demand in 2012 was $236.4 billion—an all-time high. In physical terms, demand was 4,405.5 metric tons.

Demand has been strong even despite gold’s historically high price. In value terms, demand in the last quarter of 2012 was the highest fourth-quarter total ever.

Around the world, gold buying has been robust. The two largest markets are China and India, and their 2012 gold demand was 30 percent greater than the average for the last decade.

Somewhat surprisingly, rising gold prices haven’t deterred many buyers. Even gold jewelry demand broke previous records in 2012—the opposite of what many analysts expected, when gold was up seven percent for the year.

Not only that, global financial institutions have also been strong buyers. To me, one of the most exciting statistics is that...

In 2012, central bank gold purchases hit a 48-year high!

Central banks vacuumed 534.6 tons of gold off the market last year. This is a level of buying last seen a half-century ago.

As a group, central banks have only been net buyers since the second quarter of 2009. Keep in mind whom we’re talking about here: the bowtie-wearing academics who run these banks are not people who act impulsively. They act according to large macro-trends, and they tend to follow plans that run for many years or even decades.

If you were a gold investor from the late 1980s through the 1990s, you remember how difficult it was for gold during that time. Every time the price perked up, it got slapped down again by massive waves of selling, and from whom did the selling come? From central banks! Overall, official gold sales suppressed gold for almost twenty years.

Now the opposite is true. Just as central bank selling held prices down for many years, now central bank buying will drive prices up relentlessly.

And booming demand is just one half of gold’s fundamentals. The other half is...

Sagging Supply

In a year where gold was close to all-time highs much of the time—a year when gold would finish the year at a higher price than it started, the 12th year in a row it’s done this—supply still fell.

I’ve written before about “peak gold,” and the trouble that gold miners are having in producing the yellow metal. Last year was a great illustration of this. Even near-record prices couldn’t move supply up. In fact, total 2012 supply was 62 tons below the previous year’s.

This is just the first warning of a much larger trend. Supply is struggling now, but it appears that this is going to get much worse soon.

According to a recent analysis from National Bank Financial (NBF), gold will fall off a “production cliff” as early as 2017. Specifically, production from the world’s senior gold companies will go into a steep decline.

As a mined commodity, gold is a depleting resource. Every deposit that’s currently being worked will eventually be gone. Many of the world’s most important deposits are close to exhaustion now.

To replace them, large deposits must come online. But this doesn’t happen overnight: it takes many years to discover a deposit, plan for its extraction, build the mine, and actually begin production.

Thus, by looking at current proved and possible deposits, we can know in advance how much production can possibly come online for quite some time into the future.

NBF analysts Steve Parsons, Paolo Lostritto and Shane Nagle decided to find out how much gold will actually be available to the major gold mining companies in the future. They found that the majors have enough new projects currently under construction to provide a good supply for about the next three years.

After that, production will fall.

Future gold production

The analysts call this the “production cliff.” Here’s what they said (emphasis has been added):

“As gold companies grew, too few large deposits have been discovered to sustain current production rates. Though, in recent years, the development of a handful of large mines and the threat of others to follow provided the useful impression that the Production Cliff would be deferred... No such luck. Project congestion marked by capacity constraints and resultant delays and cost pressures has forced a more orderly sequencing of projects. High-quality projects have stayed at the front of the queue with delays, while the rest have seen significant delays or, worse, been shelved...

“The prospect for a material supply contraction also bodes well for higher gold prices…

“On an aggregate basis using mine and project reserves, we forecast an increase in gold production over the next three years as Barrick, Newmont, Goldcorp and Yamana complete the construction and ramp-up cycle for projects that are already in the queue.

“Thereafter, starting in approximately 2017, production declines are in the cards for nearly all companies as the project queue and discovery frequency are inadequate to replace production.”

The effect this will have on gold prices is obvious. Even if demand doesn’t increase—which is hardly imaginable, in a world where currencies are either failing or being deliberately destroyed—plunging supply will send prices to the moon.

That’s why I said that gold’s current price stumbles were good news. This correction is a healthy sign for a long-term bull market, and lower prices are also a great buying opportunity.

And along with its physical fundamentals, remember that gold is a great investment in a world where paper assets are blowing up everywhere. Even while governments are stealing money from their citizens, national economies are melting down, and central banks are deliberately ruining their own currencies, gold remains a private, inherently valuable physical asset that can’t be defaulted upon or devalued.

Gold is a vital part of your portfolio today, not only for preserving your wealth but also for growing it. This is a great time to get more!