An Investor's Primer on Gold
Recorded March 31, 2020 | (24 mins 16 secs)
At quarter-end, Albert Lu interviewed Rick Rule, President & CEO, Sprott U.S. Holdings. Gold continues to deliver strong relative performance and was up 3.95% on a year-to-date basis through March 31, 2020. This compares to -19.60% for the S&P 500 Total Return Index.1
Updated as of March 31, 2020
|Asset||YTD||1 YR||3 YR*||5 YR*|
|S&P 500 TR Index||-19.60%||-6.98%||5.10%||6.73%|
* Average annual total returns. Bloomberg. Data updated as of March 31, 2020.
Albert Lu ("AL"): This week we promised viewers that we would do a deep dive into gold.
Rick Rule ("RR"): Let’s frame the discussion in two parts. First, gold the commodity, aka the physical and second, gold securities.
AL: I want to ask before we begin, which vantage point will you be discussing these topics: Rick Rule the investor or Rick Rule the speculator?
RR: Let’s begin with Rick Rule the investor. I believe that one invests before one speculates and we’ll talk about why that’s important later in the discussion. Let’s start with gold itself. I think it’s important to say now that the wind is very likely in gold’s sails. That is, that the macro set of circumstances strongly favors gold. I’ve probably had 50 questions in the last four weeks as to why gold didn’t respond more dramatically to the liquidity crisis, so let’s address that first. Gold did respond to the liquidity crisis — people who owned gold had liquidity and their liquidity was called on. They had to sell what had a bid, that included gold, to add to the liquidity.
The Sprott trading desk, which as you know, is very active in the physical bullion market, heard from their own sources that as much as $60 billion worth of gold was held in leveraged-long commodity trading accounts, [with] some of these accounts leveraged as much as 33:1. When credit dried up overnight, that gold had to go to gold heaven to extinguish the credit. On top of that, gold held in other leveraged, even general securities, accounts often had to be sold to meet margin debt. The truth is that gold’s deep liquidity served the buyers in times of crisis as it always does.
Gold is Impacted by the Purchasing Power of the USD
It’s important to note, that if you look back at past liquidity squeezes—by this I’m thinking about primarily 2008 but also 2000, 1987 and 1988—that the crisis itself, the panic [and] liquidity crisis, didn’t drive the price of gold because gold [was] sold off to meet the needs of liquidity. What drove the gold price subsequently was the policy response to the liquidity crisis. The big thinkers of the world, the central banks, the legislators, those kinds of people, always seemed to deal with liquidity-driven crises with three things: spending stimulus, quantitative easing and of course, artificial lowering of interest rates. It’s that triumvirate—spending money we don’t have on things we don’t need, conjuring money out of thin air and artificially reducing the compensation for saving—that moves the gold price. The most important determinant in my career of the gold price—I’m not trying to say that there haven’t been geopolitical events or other things moving the price of gold—but the thing that’s moved the price of gold mostly in my career has been faith or lack of faith, in the ongoing purchasing power of the U.S. dollar, most importantly the U.S. dollar expressed by the U.S. 10-year Treasury.
Let’s look at the factors behind it, which we’ve done before but let’s summarize them. The first is that quantitative easing, which is adding to the stock of currency with no basis—this isn’t borrowing—this is conjuring currency [which] must, by itself, debase the currency, increases the float without increasing the value. The second is that the on-balance sheet operations, which is to say the borrowing, adds to an already precarious debt situation facing the U.S. government.
We’ve done these numbers before but let’s do them again as they bear repeating. At the federal level, $23 trillion in recourse liabilities, $18 trillion net of the balance sheet of the Fed and over $100 trillion in off-balance sheet liabilities. That means simply, at the federal level, the U.S. government, which is to say indirectly, unfortunately us, have $120 trillion in liabilities. It’s important to note that these don’t include state liabilities or local liabilities, nor do they include the underfunded pension funds at the public and private levels.
The Ever-Increasing Debt Burden
'Now this debt number is ugly in isolation but you need to look at the debt number relative to our ability to service it. You service this $120 trillion in liabilities with, of course, the national income taxes and fees less expenses. The problem is that the number is upside-down, meaning it’s negative to the tune of $1.5 trillion. It is, as you know, impossible to derive a positive sum by adding a column of negative numbers and it would appear that the deficit goes on ad nauseam.
The top of the equation, that is to say the credit quality of the borrower, is I think very much in question. How do we get out of this? Well, either a good old-fashioned default—it seems politically unlikely to me—or further debasement of the currency, which is to say further erosion of the purchasing power of your savings and the quantitative easing, of course, goes on. Any of our listeners who paid any attention to the Christmas tree legislation last week, by Christmas tree I mean the $2 trillion in stimulus that awarded a reward to every politically connected constituency in the country, whether or not they happen to have the coronavirus, is ample evidence of what fiscal action is all about in the face of a crisis. Every politically favored constituency got a handout. The people who need it, of course, got very little because they don’t have very much clout. Today, of course, Trump announced phase 2 which is a $2 trillion infrastructure stimulus bill. Governments are famous for allocating infrastructure investments to politically favored constituencies, so I would suggest to you but one thing: What the coronavirus has spawned is $4 trillion in additional expenditure with very little probable long-term benefit. I think it is pretty clear that, first, the debasement of the currency as a consequence of quantitative easing or counterfeiting is occurring. The second thing occurring is that we’re incurring recourse liabilities and probably non-recourse liabilities, very, very quickly as well, which means that the debit side of our balance sheet is increasing at the same time that our ability to service it is decreasing. Finally, of course, there is the reward for savings. Who’s going to buy these bonds?
The U.S. 10-year Treasury, as I look at it today, is paying about 60 basis points—six-tenths of 1%. The CPI (Consumer Price Index) stated rate of inflation is 1.6%, meaning that the government is telling you that the value of your savings held in U.S. Savings bonds declines by 1% a year for the next 10 years. To reiterate, our mutual friend Jim Grant, calls this return free risk.
Recent Events Have Been Good for Gold
This conjunction of factors—the debasement of the currency, the deteriorating balance sheet and the extraordinarily low [return] to investors for assuming risk to their purchasing power—I think can only be good for gold. When? I don’t know. Again, looking at past crises, it often takes three or four months for the effect, or the anticipation of the effect, of the policy response to a crisis to impact the gold price. It’s worthy to note, that we are not the only ones who have noticed this phenomenon. At the retail level across the United States, retail physical products, small denomination gold products like 1 oz. gold products or 100-gram gold products, coins or small denominations silver products are either sold out of retail dealers or are only available with astonishing premiums, to the extent where I heard today that there are several one ounce gold premiums that are selling for $2,200 in the face of the spot market, which is much below that.
AL: Rick, I understand the temptation to go out and get gold now, and that makes sense if you’re not adequately diversified but, really, the smart place to be would have been to have listened to Rick Rule months or years ago, to have listened to Ray Dalio, Jim Grant, Doug Casey, even Jim Cramer, allocating 10%, 15%, 20% of your portfolio to gold and for the people who had metaphorical fires in their portfolio due to margin calls, the liquidity of gold would have been very helpful in putting out that fire.
What about people who weren’t suffering from margin calls? I think many of us tend to look at gold priced in U.S. dollars, which is a very important metric but not the only metric. You could have looked at gold as priced in Dow Jones stocks, or other stocks, or other income generating things. If you look at it in those terms, gold did respond very well. It’s responded well in terms of the dollar, with six straight quarterly gains, but in terms of other assets, it’s really done well. Should people be looking at maybe moving out of gold to take advantage of some of these opportunities in, you know, productive assets?
Most Investors are Underinvested in Gold
RR: My belief is that almost all investors, including most investors who listen to us who are inclined to like the gold story, are still under-invested in gold. I say this for two reasons. A major bank study, which I read, and I’ve quoted it before in interviews with you, says that between 0.3%-0.5% of savings and investment assets in the United States involve precious metals or precious metals securities. That may have gone up because the denominator has declined, the value of the Dow is an example but the three decade-long mean was between 1.5%-2%. Gold is still very broadly under-owned and I would suggest it’s even under-owned among people who are listening to this broadcast. The second thing is that when you have a circumstance where confidence is compromised, the gold tends to not move 10% or 15%—you’ll remember the early part of the decade that was 2000 to 2010 gold began that decade at $252 an ounce if my memory serves me well and ended the decade closer to $1,900 (in 2011).
When gold moves it tends to really move, so yes, the gold price in U.S. dollars has moved from $1,100 to $1,600. The gold price in Canadian dollars, Australian dollars, euro, yen, yuan has moved even more. The truth is that the circumstances that would cause a rational investor to own gold are very much intact and we are very much in the early days.
A Small Amount of Gold Can Generate Portfolio Protection
Does this ignore buying productive investments? Of course not. Gold moves so well that a little bit of it in your portfolio generates a whole bunch of portfolio insurance. But by way of a little bit I mean somewhere between 3% and 10% of your portfolio. I would suggest that most of the people listening to this broadcast have 1% or 2% of their portfolio in precious metals, even today. Others among you, and you will know who you are, have adequate amounts of gold in your portfolio. Congratulations. I’m sure you don’t need my congratulations; you are already smiling. The truth is, for two reasons, the macro circumstances and also the extraordinary performance of gold when it performs, I would suggest that it isn’t too early to buy now.
What’s important, irrespective of the form that your precious metals ownership comes in, [is] that you have some precious metals in your portfolio to shelter you against the policy responses that we see from the current economic circumstance.
AL: Let’s shift the discussion to gold equities now, Rick. The same case that you make for gold, it trickles up to the gold equities. But how are they different and how would you approach them from an investment point of view?
RR: As they are different we’re going to delve into a little history here because in my career gold has moved and then the gold stocks have moved and the gold stocks have moved because, first of all, the gold stock buyer is less of an insurance buyer. The gold buyer was an insurance buyer. The gold stock buyer is looking for outperformance in a company and it has been my experience that the gold stocks move after the increase in the gold price has been reflected in the income statement and the balance sheet of the individual companies.
The Biggest and Best Gold Stocks Move First
What happens historically is that the biggest and best of the gold stocks move first. Then, the second tiers move as people go down the quality trail. Then lastly, the junior producers and the juniors move last but they move in fact, the farthest. It’s important to know though, that the gold stocks move in response to gold and gold moves in response to policy. The distance in time before the crisis and the move in gold equities historically has been six to nine months, because the increase in the gold price has to show up in the income statement of the gold producers.
It’s important too, Albert you didn’t ask me this question but I’m going to use your questions [as] a platform for a statement, that the strong U.S. dollar relative to other currencies is an important consideration in the gold equities. If a gold company is producing gold in Australia or Canada with declining currencies, what it means is that the costs of those operations are declining in U.S. dollar terms. The company’s inputs are declining at the same time that the price that they’re receiving for their product is increasing, which is great on margins. This is also important, usually one of the top three most vital inputs in a goldmine is energy, fuel as an example and the incredible low prices that we’re seeing for oil and the increasingly low prices that we’re seeing for refined petroleum products, as well as other forms of energy, lower the input costs for gold miners.
I would suspect that the impact of the increasing gold price will have on the income statements of gold mining companies will be particularly impressive for companies who produce outside of the United States where their costs are declining as a function both of energy prices but also declining currencies like the Australian dollar and the Canadian dollar.
The Impact of Lower Energy Costs on Gold Miners
AL: Now, related to energy, is there anything in place, hedges or things like that, that will prevent the lower energy prices from showing up on the income statements anytime soon?
RR: There may well be gold producers who locked in energy prices for fear of energy price increases that now will show losses on hedge books. I’m not familiar with that. Certainly, there are a reasonable number of gold producers who looked at the increase in the gold price pre-COVID-19 who had hedged gold production to lock in what they thought might be high gold prices. Those companies, while their hedges are in place, will not benefit as much as they would have had they been unhedged. The truth is, the magnitude of the gold price increase and the magnitude of what I believe will be the gold price increases to follow will be such that the industry as a whole will shake off the hedges without too much damage to either the income statement or the balance sheet.
AL: When shopping for mining companies do you prefer mining companies that are exposed to the markets; unhedged to energy, unhedged to currency, unhedged to the gold price?
RR: That depends. The most important consideration for me, for most investors right now, is simply to buy the best of the best. We’ve talked about this in prior interviews, particularly that interview with the gold mining index chart, which we could of course make available to anybody who wants it. The magnitude of the increase in gold mining equity prices during recoveries from oversold bottoms like this, it’s so extraordinary, if my memory serves me well 150% to 1,200% over periods of time as brief as 17 months or as long as 42 months, that you don’t have to get too cute.
Buy the best of the best even though, ironically, the best of the best underperform the index over the course of the market, they outperform early on and they give you most of the market performance but with much less risk. More sophisticated strategies come around understanding gold companies well enough to understand those companies that will have production increases over the next three to five years or offer the most leverage.
To go looking for companies that offer the most leverage for gold involves, paradoxically, having the courage to own the high-cost producers whose operating margins increase the most when the gold price increases and finding those companies that had the courage, or some would say the foolishness, not to lock in prices that they thought were high prices. Certainly, the unhedged producers generate the most speculative appeal.
Time to Consider Gold
What I would ask our listeners to do right now, the ones who don’t own much gold or gold equities, is buy some gold [and] pray that the price doesn’t go up because the circumstance that leads to vastly higher gold prices is invariably hard on the rest of your portfolio. After you’ve done that, position yourself in gold equities, the best of the best gold equities.
AL: A follow-up question regarding energy, I understand the argument that foreign gold producers would have the advantage in the currency, particularly as it applies to labor. What about the prospects for a U.S. producer with domestic oil production exceeding the demand and the possibility of having oil available, sub-$10 a barrel domestically? Would that provide any kind of tailwind for those producers?
RR: Huge tailwind. Most American gold production is in northeast Nevada in the Battle Mountain-Carlin Trend and these are gigantic open pit operations with 400-ton haul trucks. These haul trucks’ fuel consumption is measured in gallons per mile, not miles per gallon. Similarly, remote power often relies on fossil fuel to run the mills and things like this. Oil and other forms of energy are enormous input costs in the U.S. gold production industry because the U.S. gold production industry takes place on such a massive scale. It’s not a labor-intensive business. It’s a capital- and fuel-intensive business. The tailwind that will be enjoyed by the big American producers, Newmont and Barrick in particular, as a consequence of low oil prices on their U.S. operations are difficult to overstate.
AL: That’s all I have. Do you have any parting thoughts for the viewers?
RR: Yes, I do. The truth is, that many of our viewers are more sophisticated gold equities buyers. There are people that already own the best of the best. This is the time for those people to begin to look at the best of the rest. In a normal circumstance, gold moves, then the gold stocks move. Silver bullion often moves concurrent with the gold stocks, and silver stocks move last but often the furthest.
|1||The S&P 500 or Standard & Poor's 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies. You cannot invest directly in an index. TR, "Total Return", represents the index with dividend income reinvested.|
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