What Happens When Tech Tops Out?

Podcast Transcript

Ed Coyne: Hello, and welcome to Sprott Radio. I'm your host, Ed Coyne, Senior Managing Partner at Sprott Asset Management. I'm pleased today to welcome back Fred Hickey, founder of High-Tech Strategist, a monthly investment newsletter with over 30 years of intensive market research, and John Hathaway, Managing Partner and Senior Portfolio Manager at Sprott Asset Management with over five decades of investment management experience. Gentlemen, thank you both for joining Sprott Radio.

Fred Hickey: Glad to be here.

John Hathaway: Thanks, Ed.

Ed Coyne: John and Fred, let's go back two years to our last conversation on Sprott Radio. Effectively, it was a macro gold roundtable. Today, I want to discuss what's happening in the general markets more broadly. Fred, let's start with you. I know two years is a lot to cover, but what's been going on over the last two years?

Fred Hickey: We've had a reemergence of the stock bubble. We had huge declines in the stock market in 2022 and the worst bond market in history in 2022. Then Treasury Secretary Janet Yellen found a way to get more money into the economy and the financial system by taking down the reverse repo (RRP) account, which had $2.5 trillion at the beginning of 2023. Now, it's down to $400 billion.

By issuing many treasury bills, she could pull out $2.1 trillion. Much of that went into the stock market, just as the money printed in QE1 to QE2 and QE3 plus did several years ago, not to the consumer as it did when the Fed printed $5 trillion. The government handed out stimmy checks that lifted consumer inflation. This has been financial inflation. As a result, we've had a huge reemergence of this bubble. That's where we are right now.

That bubble feeds the U.S. economy because much of it is very weak. Retail sales are weak, housing is a disaster, and industrial production is soft in many other areas. All the wealth created lifts the U.S. economy and makes it the strongest economy in the world right now.

Ed Coyne: That's a good point; it is the strongest economy in the world. On the surface, things look like everything's working; the economy's working. Employment seems to be in check, and inflation's coming down. The Fed hasn't lowered rates yet, and gold's also doing well. John, let's shift to you for a minute. Have you been surprised by the strength of gold, given that everything seems to be rosy right now on the surface, but yet when you go underneath, not so much? What do you think about that, and where do you see gold right now versus going forward?

John Hathaway: Well, two things. First, the strength of gold has nothing to do with U.S. or European investors. It's all about central bank buying. The reason central banks are buying is mainly the BRIC nations, which are trying to rearrange the plumbing of global commerce away from the U.S. dollar. That has all kinds of implications down the road, which we won't have time to get into today.

The other thing, in your question to Fred, which I like to go back to, is the general perception and the complacency that Chair Powell is going to stick a soft landing and there won't be any long negative consequences from higher interest rates, 5% on the short end. Again, we have an inverted yield curve. Let's come back to that point because it seems to me that part of the complacency and what Fred talked about is the issuance of a lot of short-term treasuries, which have basically inflated financial assets.

Fred, you mentioned in your letter that that might be coming to an end. What if we have something that the vast proportion of the investment world is not contemplating and positioned for, which is a recession? Everything I look at, and I confess to not being an economist, and I'm proud of it. Still, all of the restaurant sales, hotels, and a lot of these consumer discretionary sectors are rolling over. Let's talk about that a little bit more.

Fred Hickey: Only the high end is doing well right now. A survey showed that 65% of people making over $60,000 a year suffer financially. By the way, the wealth created in these last couple of years keeps people traveling worldwide, going to concerts and sporting events, and paying huge dollars for them.

John Hathaway: Yes. Ticket prices for concerts and sporting events are crazy.

Fred Hickey: That's lifting part of the economy while much of the rest is suffering. It's a bifurcated economy, and that's problematic if the wealth disappears. If a handful of stocks determines the wealth, as it is, as of last week, three stocks, Apple, Microsoft, and Nvidia, were worth $9.9 trillion, which was more than what the whole Chinese stock market was worth. It's epic.

On a price-to-sales and price-to-market-cap basis, valuation levels are higher than in 1929 and 2000. It's intense and very narrow. The ten largest stocks account for almost all the year's gains in the stock market. You see the breadth. Bank of America put out its report last week. They talked about breadth being breathtakingly bad.

The average stock is not doing well. The Russell 2000 is a little lower than it was in 2021. It's these small number of names. If they break as they will because they're grossly overvalued, then the wealth effect could go away, and then it could join the rest of the economy, and then you have a recession.

Ed Coyne: Why do you think the world's not paying attention to that? To your point, the high end is still traveling and spending money, but the middle and certainly the bottom end are starting to struggle. Again, on the surface, it seems like things are going well. Why is no one focused on this or paying attention to this? Or is this classic peak market behavior?

John Hathaway: Well, it's convenient to the consensus view of the stock market. If the things that Fred and I think are more likely to happen, then you wouldn't have valuations at these levels. I believe it's just convenient to avert your eyes to the reality of the struggles of the middle and lower classes.

Ed Coyne: Let's talk about some things that are more likely to happen. In your mind, if you had to pick two or three things that you're concerned about today, John, let's stay with you for a moment on this. What are some of those things that our listeners should be thinking about?

John Hathaway: Much of what Fred's talking about is the overconcentration and risk in the markets at these valuation levels. Fred explained it very well. If that is the single strand or one of the few strands propping up the economy, and if that is to go away, then I think there are some rude shocks lying ahead for complacent people, averting their eyes to things we're talking about. I'm sure Fred has some thoughts on that, too.

Ed Coyne: Thank you, John. Fred, what are you thinking about that? What other speed bumps are out there that are obvious to you that maybe others aren't paying attention to?

Fred Hickey: No one in Washington, at least, is paying any attention to this tremendous spending by the U.S. government. They just increased the deficit estimate, the CBO, by 27% last week to $1.9 trillion. That's in a non-direct war scenario here. Also, in an economy that's still growing, if you go into a recession, you will see $3 trillion in deficits, and they're in $35 trillion in debt.

That's a problem when money seems to be drying up a bit. The liquidity in the U.S. treasury market is extremely low. We're seeing many options now, not fail but do poorly. There isn't as much demand anymore. Part of the reason is the Fed is not buying anymore. They were the largest buyer. They're still tightening with QT, quantitative tightening.

That's not the level it was, but it's still $60 billion monthly. Then you don't have that RRP account, which they've been tapping into. It's tapped out. That's one of the reasons why the breadth is so poor in the stock market. It doesn't appear to be enough money to lift all the stocks. It's getting narrower and narrower, and it's very dangerous.

Ed Coyne: You just talked about this recently in the current newsletter, and I thought you did a great job covering what's going on out there today. Peak gen AI hysteria. Is that one of the symptoms? Talk about that because what's going on in tech right now and how that's driving things to me seems obvious, and this is not sustainable, but can you expand on that a bit?

Fred Hickey: Usually, when there's bubbles, there's a theme. We had the 2000 bubble, and that was the internet. That was very valid, but it got ahead of itself, and they overbuilt too much capacity in fiber optics and computer servers. We've had other great bubbles and canals and railroad-driven. Sometimes, though, it's tulip bulbs. This is somewhere in between generative AI.

AI has been with us for decades. IBM's Watson was introduced almost 15 years ago. We've been making improvements in people's lives with AI. That's been going on for a long time. Nothing new. We had the development of these large language models, which is the gen AI part of it, and its word salading. Microsoft saw the possibility of going after Google search, and they were going to use this Open AI, generative large language model, to do so. They poured all kinds of money into that. They put $10 billion into Open AI. They then put a bunch of money into NVIDIA GPUs.

Google saw that and triggered their buying, which triggered Meta's and Amazon's buying. The costs are high. The payback isn't there, and we see it in the surveys. A couple of weeks ago, one survey showed that only 5% of the companies trying to use this generative AI are getting any payback. As a result, there are cutbacks in spending and planned spending.

You have the stocks going crazy, going higher and higher and higher, yet the generative AI benefits are very low, and the costs are high. What could go wrong there? Well, there's a reckoning coming.

Ed Coyne: To that point, John, you mentioned a moment ago that it's central banks and the de-dollarization of what's driving gold, but do you see gold playing a role in this AI shift or this AI hysteria? What's gold's part in all of this?

John Hathaway: The connection is that if the emperor has no clothes, and Fred has explained it very well, I think people will look for other things to do to protect capital and gold would be one of the answers. It takes me to the question you asked earlier: what will be the next leg in the gold price? I think it will repeat what we saw in 2000, the bubble bursting. Nobody can predict exactly when, but we can certainly explain why it is a bubble and bubbles have a history of deflating.

How would public policy respond to the one thing propping up the economy? If that isn't there, then I think you would see much more in the way of deficits and much more in the way of, for lack of a better phrase, money printing by the Fed. It is a panic reversal, not a soft landing, but something that demands warp-speed money creation. One is that you take away the thing that's been keeping investors' focus away from gold and, two, fundamentals that would depreciate the dollar even more than it has over the last 20 years. That's how you get to $3,000 or $3,500 gold. We're not there by a long shot, but that is certainly on the horizon.

Fred Hickey: The difference between now and 2000 is that inflation wasn't on the radar screen then, whereas we've had a period of high inflation, and we're still suffering from it. It's come down, but it's still high in a lot of areas, like services and wages and that kind of thing. I mean, gasoline prices are up 19% this year. That's going to have another effect on the numbers in the future.

People are now aware of inflation. They saw food prices rise 36% over the last four years. Everyone is aware of that. It's a big issue in the upcoming election campaign. In 2000, that wasn't the case, but it is now. People are concerned about the debasement of the dollar. They're concerned about inflation, making it harder for the Fed to act quickly, as they have in recent years because they have to worry about inflation.

It's interesting that in 2000, there was no interest in gold. We would see outflows out of both stock funds and as well as other people selling gold. Today, it's different. We've seen the outflows from the west out of the ETFs. We've seen massive outflows. If that had been the case in 2000, we'd be down a lot in the price of gold, but we're not. We're not because the rest of the world sees things differently than the U.S. does.

They're concerned about inflation. They're concerned about the debasement. They're concerned about de-dollarization. They're concerned about the weaponization of the dollar and what happened with Russia. Offsetting these hundreds of tons of gold selling that's occurred in the last couple of years is 1,000 tons of central bank buying in 2022. It's over 1,000 again in 2023 to a record 290 tons in the first quarter of this year. The people throughout Asia then buy them. They're the ones that are driving the gold market these days.

What we've had here is the price of gold that's gone up. It broke through record highs and triggered all kinds of technical buying because it broke through the $2,070 level and went further. The chart looks great, and it's an eight-year cycle. It's the beginning of that. The cup and handle are in place, and it looks perfect, yet we haven't had any investment by the West, as John had spoken about earlier.

That piece comes in once the stock market breaks, and the alternative becomes potentially gold, especially with the bond market being so poor. With rates going up over the last few years, the bond market has been a poor alternative. It isn't the safe haven it once was.

Ed Coyne: Fred, in your most recent newsletter, you also discussed China attempting to curb gold's enthusiasm for moving higher. Talk about that because you're right; it seems like the West has moved away from it as the East continues to embrace it, yet even China was unsuccessfully trying to dampen the general market's enthusiasm. Can you unpack that a little bit and walk us through what you saw there and what you witnessed?

Fred Hickey: I don't think they're trying to dampen enthusiasm for gold. What they were trying to do was reduce the price. The first decline peaked at $2,350 or something like that. First, $2,370, I guess it was. They raised margin requirements to try to dampen the enthusiasm. Then, most recently, we went up to another high, $2,450, and they came out. They didn't say-- the Bank of China wasn't adding to the reserves, which you can't trust because they go for years and they don't tell you that they're buying, and they happen to know they were continuing to buy, and they plan to continue to buy.

The Chinese play games with prices. They do it in the copper market and other markets as well. They wanted to see that price come down. It was too high, but they wouldn't stop buying gold. They've been buying it for decades and will continue to do so. You might not hear about it, but they'll go on for a long time. I don't know what will happen next month if they'll announce that they bought again or not. I don't know that, but I know they're buying. It's more of a damping down enthusiasm for the price and making it easier for them to buy at a lower level.

Ed Coyne: Speaking of that price, John, were you surprised to see gold not only break through that $2,300 but, more importantly, hold that price, or do you think it's still too low given the current landscape?

John Hathaway: I wasn't surprised that it finally broke out of this three or four-year consolidation range trade between $1,800 and $2,000. What surprised me was that it happened without any participation from folks in our part of the world. That suggests to me that when that latent buying interest gets activated, I would think that that's where our next leg comes from. That is why it's so important to draw the connection between the stock market bubble and what would it be that would get people in our part of the world interested in gold again, which they haven't been.

Ed Coyne: John, you've seen this before. We talk about the West regaining interest in the gold trade. Can you draw some parallels to other times when you saw the West embrace this allocation and what that looked like, not just for gold? Let's also shift gears and talk a little about the gold equities or the miners and what that has looked like in the past.

John Hathaway: Let's look back at the launch of GLD in 2004. It went from zero, I think, to Fred, who will probably have the number off the top of his head, but I think they added between 2004 and 2011, which was the peak on the order of 500 or 600 tons.

Fred Hickey: Even more than that. It went up to a peak of 1,300 tons.

John Hathaway: What if they tried to buy 1,000 tons or 1,400 tons in this market, with the Chinese not going away and probably still buying? Make up your own number, but gold, to me, is still underpriced at this level. Ed, you touched on something that's near and dear to my heart, and I think maybe Fred’s, too, which is what's going to light a spark under these gold mining stocks.

It's been super frustrating for me as an investor. Our clients are investors in gold mining stocks, to see the lack of interest even in the face of tremendous fundamentals and widening margins. The average gold price in the first quarter was something like $2,100. It'll probably be $2,300 or $2,350, something like that. Margins are expanding, and the stocks are dead in the water.

Yes, they've risen from depressed levels, but they're still, in my mind, nowhere where they ought to be. I keep asking myself, "What will it take?" I'm guessing it will be disenchantment with the stock market, as we now know it, and maybe a disruption of this complacent view that the Fed will stick a soft landing and that we're facing a recession forcing dramatic changes in public policy. I think combining those things will light a fire under the gold stocks. I'm locked and loaded, so we're just waiting for this to evolve, and I think it will.

Fred Hickey: I do think that this earnings period is going to be dramatic for the miners, and that's going to draw some attention. I calculated the average price to be $2,340 versus 20-- it was $2,072. You're talking about a $270 increase from Q1 to Q2. Most of that will be increased margins for these gold mining companies. It looks like a 35 to 40% increase in the margins of these companies. Their margins were pretty good for a lot of them in Q1. They're just going to be fantastic in Q2.

I'm hearing from the hedge fund community that they're interested in some bigger names. I hadn't heard that before. I'm talking about the stock market names. They've been involved in the gold and silver, not the stock market names, but the institutional money is not involved at all yet. It's the pension funds and insurance companies and those things that aren't involved- that's what you see in GDX, ETF. They had the same number of shares outstanding, $388 million, six years ago when gold was half the price.

It's stunning that there's so little interest in them, yet they won't be able to avoid them if the earnings go up and the stocks start moving. It's a very narrow market, and we talked about just these small AI-related companies. We've seen big declines even among cloud companies. 8 of the 10 top cloud companies are near 10% declines in their stocks last quarter on their numbers. That's how narrow it is. They have to look for other areas that might be performing. They're running up against limits to how much NVIDIA they can have and how much Apple they can have. These strong earnings could help to trigger some interest.

Ed Coyne: John, I know you've mentioned in the past the general health of miners from a cashflow standpoint, from a dividend yield standpoint, all these different things, lack of debt on their balance sheet, but the naysayers would say, "Well, but the cost of extraction is going up, inflation's going up, and cost of employees is going up." Inflation's starting to flatline from where it was a year ago. These margins are expanding. I wonder if you could give us some examples of how much quality we see in these miners today.

John Hathaway: I would not say that costs are going down, but the rate of increase is slowing down and equates to margin expansion. The other thing that strikes me is that a number of companies have just completed large new mines in safe jurisdictions. Think about this: they had unproductive capital for years because it was tied up in a mine build, which is a torturous multi-year process. Billions of dollars that were sapping returns on capital will suddenly flip to producing returns on capital because they've started up, and in some cases, very large new mines.

That gets further down the road and is more of a sweet spot than just margin expansion. It would be a step change in corporate cash flow from startups of big new mines. That's something that we're emphasizing in our stock selection. Fred, you've noted some of this, some of the names where this is taking place. That dynamic element to fundamentals will take us even further than the expansion of margins we've already discussed.

Fred Hickey: Some of these companies are seeing declining costs already because production is going up, even with the inflation that's occurred in labor in some other areas.

Ed Coyne: With all the ETFs and stuff out there now and this whole ongoing argument of passive versus active, does that make a case within the mining space to be more mindful of looking at active managers versus just a general ETF, or how should investors think about that as they start to shift from looking at the physical market, like you're saying, Fred, from a hedge fund standpoint to the equities or the miners? How should an investor listening to this podcast today start looking at or thinking about mining stocks?

Fred Hickey: Selectivity is important, not just buying the whole group. There are many reasons for that. There's a lot of danger in not being in the right jurisdiction. The higher the gold price, the more danger there is because you see a lot of expropriation through various means, such as taxes and royalties and actual potential expropriation that could occur.

Ed Coyne: We've covered the waterfront on general markets, both physical gold and gold equities. I'd be remiss if we didn't bring up silver just for a moment and get your views on how an investor should think about it. In many investors' minds, gold and silver go hand in hand.

John Hathaway: Quickly, silver is gold with torque. It's got a lower price point of $28 an ounce versus $2,300 an ounce. It's more accessible to retail and is a monetary metal. It also has industrial usage, which complicates the analysis, but it's a monetary metal on steroids at the right moment. We haven't seen that yet, but stay tuned.

One issue is that there's a lack of good silver mining equities. There are some. We could probably have Maria Smirnova on this podcast, and she would say the same thing: that she has trouble finding good mining equities in the silver space. There are some, but maybe just not enough to her liking. That would tell me that the ones that are pure silver plays, and if silver does catch that monetary metal tailwind, those specific silver stocks should be outstanding performers.

Ed Coyne: Fred, would you like to add to that? I know you've also talked a bit about silver in some of your newsletters. I think you even mentioned it in the most recent one. Do you have anything to add on the silver front?

Fred Hickey: I agree with John that finding good, well-managed silver companies is difficult. In safe locations, that's another problem. Silver lags behind gold; it's typical, and then it takes off and does far better than gold.

Ed Coyne: Before we sign off here, I want to touch on the Fed, which we've touched on a little bit throughout the conversation today. John, you mentioned a soft landing. From a report card standpoint, do you think the Fed's largely getting it right or have they painted themselves in a corner? Maybe we can touch on that and what that could look like for gold in the long term.

John Hathaway: I think what we've seen is the Fed is irrelevant so far because the gold price has gone up. The old mythology was that high interest rates and a strong dollar are bad for gold. We've had that, and it hasn't been bad for gold, so what does it matter in that sense? What I think matters, and I'm no fan of the Fed, is that they're in the process of making another big mistake: they'll have to hit the retro rockets on their stance of supposedly tight money.

I think they're sneakily getting away from that by shortening debt maturities. They're already doing several other things, such as pulling back on quantitative tightening and running down the balance sheets. They're sneaky about it. I don't understand the reverence for the Fed that you see in the general financial media.

Maybe it's because there are a lot of guys who make a living just talking about it. I'm ready to see the Fed reverse its current stance. I think that will generate interest in what we've talked about.

Ed Coyne: Fred, I'm seeing some head nodding there. What's your thought on the Fed?

Fred Hickey: I agree with everything that John said. In addition, though, they've been intervening in the markets constantly for years, and the intervention has to get greater each time. The last one was $5 trillion or $6 trillion, which doesn't count the $5 trillion from Europe or the ECB. At some point here, the Fed's going to lose control. They're having trouble now. The treasury department is having trouble with these auctions, and people are getting more concerned about inflation. It's going to get very interesting.

As we go forward, there may not be a tolerance for the kind of quantitative easing, the massive money printing, and the debasement that's been going on to reach-- each time we get a crisis, it creates a worse crisis because they never let the markets correct completely. They don't let the excesses completely clear. We end up with more malinvestment and with things like all this money pouring into this stupid gen AI stuff.

Then that blows up, forcing them to come in again, but now there's inflation built in and inflation expectations. I won't call them irrelevant. They may become very important in the future, but it'll be a loss of confidence rather than the confidence that people have today.

Ed Coyne: Fred, let's stay with you for a moment. Are there any other points you'd like to make that maybe I didn't address that you think our listeners would benefit from today?

Fred Hickey: I think the timing is good right now. We've had this correction. It hasn't gone very far, but it has corrected things. Particularly in the gold miners area, they're going to have great earnings numbers, and there's a chance we will get going here in the second half of the year.

Ed Coyne: Gentlemen, I appreciate you both taking the time today to join us on Sprott Radio. I hope all of our listeners benefited from this as well. Once again, my name is Ed Coyne. Thank you all for listening to Sprott Radio.