The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: Before we join our guest, which I am always encouraged by, Dave, John Embry, as he has such a great insight into the behind-the-scenes on the precious metals markets, as well as other markets. Before we join him, let’s just talk about something, though. Their group has written about and talked about a lack of gold in the system, and they’re crying foul. What they are saying, basically, is, “We’re seeing more gold sold out of the Bank of England. We’re seeing more gold sold out of the various central banks.”
David: Than actually exists.
Kevin: Than actually exists on the books.
David: It’s the issues of hypothecated, or re-hypothecated gold, where, in essence, we may not even have the gold that is sitting in Fort Knox, laced, lent, but probably not there, at least down to the last ounce.
John is a fascinating character. He plays a very instrumental role with Sprott Asset Management, Chief of Investment Strategy there, joining them in 2003, and spent a lot of time with RBC before that, managing not only the Royal Canadian Equity Fund, but also their Royal Precious Metals Fund. He has had an interest in precious metals going back some time, and brings a unique insight in that his time spent in Toronto, and certainly around the TSX exchange – that is a resource-oriented index. It’s a hub.
Kevin: For resources.
David: It is, it is, whether you are talking oil, gas, various commodities, and it gives an extra sensitivity to real things, as opposed to if you shift just a few hours south/southeast to New York City, what you end up with is a focus on structured products, and high-falutin’ finance where one product has been sliced and diced so many times that you don’t even remember what the original was, and that really is reflective of, again, the issue of hypothecated gold and re-hypothecated gold. New York loves that stuff, because derivatives are the way that you take one product and charge 10 fees on it, as opposed to just one product, one fee. It’s a multiplication of revenues, and, at the end of the day, you forget what the asset in question was.
Kevin: What was the asset? And then…
David: And where was that asset? (laughter)
Kevin: Two weeks ago, David, you talked about changing the GDP. Remember a few weeks ago the GDP was changed, they decided to just make it something better than it really was. Well, the government does the same thing. They love the paper side of things, or the things that they can manipulate, but we know that real gross domestic product is what real gross domestic product is, and it is sinking. John also has insight on that.
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David: John, great to have you back with us. There are so many things to talk about, and we have investor psychology today, which is a major issue. It is highly influenced by data points, many of which are crafted. Talk to me about what you see amongst Main Street investors, and how dangerous their perception is at this point.
John Embry: That’s an excellent question, because it is extraordinarily dangerous. The numbers that are being fed to the public by the mainstream media, basically, are propaganda, in my opinion, and yet it has worked, largely, because the public is focused on the wrong stuff and they are bullish on stocks, and they are not nearly bearish enough on bonds, and they are absolutely over-the-top bearish on precious metals, which are probably as cheap as they have been at any time in the entire bull market. So, basically, sentiment has been directed, essentially, and it is, in my opinion, dead wrong, in the sense that people are focused in the wrong area.
David: You’ve been at this long enough to see the ebbs and flows of many markets, whether it is the Dow, the S&P, the TSX there in Canada, gold and silver, of course, and you generally see market sentiment going from one extreme to the other, and these numbers are pretty critical. We have this belief that recovery is full-fledged here in the United States because the employment number continues to improve.
Recalling what Keith Hall, who retired from the Bureau of Labor Statistics not long ago, has said, the employment-to-population ratio is a better gauge of the real employment situation, and he said that 24% is probably the right number to be looking at. U3 at 7.6% does not represent the employment situation, and yet investor psychology is such that we’re happy, and happy days are here again, because of the data points that we have received. Inflation is another one. We don’t have inflation today if you are looking at the CPI or PCE, like the Fed does. What about inflation? If it’s not here, when would we see it?
John: Well, there is inflation. As you know very well, in the last 20+ years, the methodology has been changed so dramatically in how they report inflation, with hedonics, and changing the mix of the CPI, and all sorts of things. But I would dare say that the CPI is dramatically understated, and then they leave out energy and food, which are probably the two things that people consume every day, and have gone up dramatically.
It does two things. One, it hoodwinks the public, to some extent, and secondly, it leads to an overstatement of real growth because the nominal growth is a combination of real growth and inflation, so if the inflation is understated the real growth is overstated, and that’s what I believe is going on.
David: On top of that you have one of the elements within that inflation statistic, the CPI, or even the core CPI, rent, which is now at an all-time high, and yet it’s not filtering through CPI. Have they so scrubbed the number – is it just one more number to join the irrelevance parade?
John: It’s actually shocking, because one of the first things they did many years ago is to remove housing and come up with the idea of imputed rent, because house prices were going up rapidly and imputed rents weren’t. Now, we’ve got the shoe on the other foot because when all these houses haven’t been bought by foreigners, and by hedge funds buying up huge blocks of houses, now they’re just renting them out and the rents are moving quite sharply. I don’t see any reflection of it in the CPI number, either, and I think that’s wrong.
David: Interestingly, enough, Blackstone and Deutsche Bank are now talking about securitizing those rental pools and developing what is really just an exit strategy for themselves. They’ve put together the product and now they want out. It’s very interesting. Where does the opportunity lie? Well, I think they’re capturing the gains as they see appropriate.
There are some issues in the gold and silver market which are compelling. You mention them being at extraordinarily low levels. When you look at the gold and silver market today, they are the market pariah. Is this a neglected opportunity?
John: I think it’s an incredibly neglected opportunity, and I’ll tell you why. The price of gold and silver were taken down violently in the paper market. To effect that, somehow they had to come up with a source of physical gold, and they did. Essentially, they got everybody wrong-footed on GLD, and by shrinking the size of GLD they’ve taken north of 500 tons out of GLD. And at the same time, a report came out yesterday from, I think, a very qualified source. He was looking at the numbers of the Bank of England, and somehow, their gold in their custody had dropped some 1200 tons since February.
This would go a long way to explaining how they can bring the gold price down so far, because you needed physical supply, and there are two numbers, with what came out of GLD, and what conceivably has been routed through the Bank of England, because England doesn’t even have 400 tons. But somehow, according to these numbers, they may have disposed of 1200 tons, and when they were confronted on this point, they sort of took the fifth.
David: That’s interesting. It’s, essentially, an orchestrated move lower.
John: Without question.
David: And the shift has been a dramatic shift from West to East, in terms of the ownership of those physical assets. What does that do, in terms of setting up China, long-term? I assume that not only India and Turkey being big buyers, but the important numbers into Hong Kong have been off the charts, and I assume that is something of a surrogate for Shanghai and the mainland. Where do you see the renminbi ten years from now? Not tomorrow, but ten years from now, in terms of its role as a contributor to the world monetary system?
John: I don’t think that there’s any question that the Chinese have every intent to acquire enough gold that they can eventually, to some extent, back the yuan, or the renminbi, whichever you want to call it, with gold. At that point, given the weakness in the rest of the fiat currency system, they would be the dominant nation by having the very strongest currency. These people are smart. They’ve seen what the U.S. got away with by having the reserve currency, and I think it’s fully their intent to supplant the U.S. in this role some way down the line. The question is, how long is it going to take, and that is the one issue. I don’t know how long it will take, but they are sure buying it hand over fist.
David: It’s a deep game that they play, and just like a chess master, you may think 20 moves ahead instead of just the next two, sacrificing a pawn here and there to make greater progress.
There is the issue, though, with China, of a slow-down. It was double-digit for over ten years, 10½% growth on average, and now it’s 7½, maybe that number is even fabricated.
John: I don’t believe 7½, quite frankly. I think that they are doing much what the U.S. has been doing and kind of fudging their numbers.
David: Oh, we’ve exported the quality of data collection, have we?
John: Oh, yeah, I know. But I found it fascinating, the former World Bank Chief Economist and advisor to the Chinese government Justin Lin criticized widespread pessimism amongst economists and investors about the outlook for the Chinese economic growth in the next few years. He basically came out and predicted that it would grow between 7½ and 8% for the next 20 years. I think that will probably be seen, in the fullness of time, as the most ludicrous statement anybody in a position of authority has ever said.
The fact is, they have a big debt problem, too. They have the most unbalanced economy in the world, in the sense that so much of their economy has been capital spending and export, and the idea that they can do a clean move from that into a consumer-driven economy, given that the consumers are the ones that are employed in these industries that are over-capacitied, I think is a very hard leap. Do I think they will continue to grow? Yes, because they have a lot of people that they are going to employ, but they aren’t going to grow at anywhere near the rates they have in the past. But having said that, I don’t think that’s going to detract, in the least, they still have unbelievable numbers of reserves that they are going to marshal and be buying things like gold and other real assets.
David: Well, you’re the right person for this next question, because you’ve spent time, not only in New York, but obviously in Toronto, and the TSX is an index you know well, which tends to be more natural resource-oriented than what we have as our indexes here in the U.S. With a slow-down in China, going from 7½ to 8%, unrealistic, to probably something more sustainable at 3 to 5%, with 5% being the outside number of sustainable.
John: Yes, I would agree with that number. I think that they can maybe maintain that, but these ideas that they are going to maintain anything close to what they have is, I think, just preposterous.
David: We’ve seen, already, a slowing in Brazil. We’ve seen a slowing in Australia. We’ve seen a slowing in Canada. The TSX is not where it once was. Where do you see the demand for natural resources – supply and demand being critical to price – where do you see the demand coming from if markets are made at the margins and we see the margins starting to be squeezed, at least on the China side?
John: I think the outlet for industrial commodities is fairly bleak, really, in the sense that I don’t see the source of demand anywhere in the world if China slows down. China, essentially, laterally, has been the engine. But you look at the rest of the BRICs, they’re certainly having their difficulties, and I see zero vitality in the rest of the industrialized world. I’m a great believer in Austrian economics and when you have a problem with excessive debt in a system, by definition, you really can’t grow by any sustained amount. And in that event, I don’t see the demand for basic industrial commodities, and so consequently, outside of gold and silver, I’m sort of very neutral-to-negative on that whole sector.
David: We overlap tremendously there, because it’s concerning to me to see the price of nickel and copper, and of course, copper hasn’t completely broken down, but relative to where it was two years ago, it has suffered, like the rest.
John: The one flip side of it, the fact is, that these are real assets, and perhaps the Chinese would rather hold copper than American dollars. I think there is some game in that aspect going on. But on a pure supply/demand basis, I don’t see them as being very attractive. Debasement of money might keep the prices of the commodities more elevated than they otherwise would be.
David: We’ve also seen a shift here, going back to gold and silver, of being accepted collateral. Europe has long allowed that on an individual basis. The Bank of International Settlements is certainly open to this. What role do you think gold plays in the central bank community? Again, not necessarily a front-and-center, or well-publicized role, but the same role that treasuries have perhaps played, as a reserve asset. Do you see that trend continuing with various world central banks?
John: The problem I have with that theory is that I honestly believe that a lot of this Western central bank gold is not in the vaults because it has been leased, and what have you. And consequently, you can see the Eastern central banks accumulating it aggressively. And I am deeply troubled, as a Westerner, to see this real measure of wealth flowing from the West to the East. I don’t think that really says a lot about the future of the West. But I agree with you, I think that if bonds get into the degree of difficulty that I think they are ultimately going to get into, gold could re-assert itself as a major asset in the central bank world, but it might be driven more by the Eastern central banks.
David: Not exactly a concept that the Western central banks are open to, because it is something of a constraint, or a restraint, on their normal activities.
Switching gears from gold to a subset of gold, relative to gold, mining shares are the cheapest they’ve been, maybe in a decade, maybe longer than that, but cheap assets can always get cheaper. How do you navigate those waters as a professional?
John: I think now that the pricing mismatch with the stocks is so extreme based on any historical relationships with bullion and what have you, and the fact that bullion, itself, gold and silver bullion, is so depressed, I think that this might represent one of the finest, if not the finest buying opportunities in the history of these shares. And the fact is, if you buy them for cash, picking the bottom is a difficult thing, and they could have another test of the lows, for example. But it’s one of these things, it’s a risk/reward ratio, and it’s a probability issue. I think the risk/reward ratio is massive to the upside, I think it’s 10-to-1, or maybe more than that, compared to the downside risk. I think the probability of this playing out over the next 2-3 years is probably 90-95%.
I would advise people, basically, start picking away at them now, and if they get cheaper, just average down a bit, because I think, in the fullness of time, you are going to be astounded at how much money you are going to make, with the proviso that you are picking the right companies, because there is still a lot of junk in the sector, and a few of them won’t survive.
David: So the probability playout is relatively high, the risk/reward is reasonable…
John: No, the risk/reward is extreme, actually, in favor of the reward.
David: So that the key element here is where we started – investor psychology.
John: In the short-term timing, I honestly believe that we will see a major change in both direction and trend sometime in the early fall.
David: What would you say, is there a particular catalyst? Or maybe that doesn’t even matter. I know the context is fairly well set.
John: I think the catalyst will be, finally, the recognition that the physical gold in the system has been hypothecated and re-hypothecated so many times, there are so many claims on each ounce or bar of gold, that there is going to be a collective realization that, “Oh my God, if you don’t have the real stuff, you’re in trouble.” And at that point, I think the price will start to go berserk.
David: In 2005 and 2008, we had corrections in the price of gold. They ended up being excellent buying opportunities. In fact, if you could rein in the negative psychological elements there in the fall of 2008, you were picking up quality companies for pennies on the dollar, and it was very profitable to own them. Even with the massive correction you’ve seen, you’re still knee deep in clover.
But one of the things we saw at the same time, 2005 and 2008, was a massive short position in gold amongst the speculators, not the commercial interests, per se, but the speculators. If you add up 2005 and 2008 short interests, you are getting close to what we have today, over 130,000 contracts. I’ve seen even higher numbers than that, but I’ve just been unable to substantiate that. Where do you go in terms of the price with those kinds of short positions?
And let’s say, for instance, there’s a fly in the ointment. I think there is a short-covering in the offing here in the next few months. But couldn’t you allow some of those contracts to just come due and settle in cash, rather than force the issue on the open market?
John: Well, I think that’s going to happen. I don’t believe the physical gold is available, and I think some people are going to be settled in cash. In that instance, if you really believe as strongly as I do in the ultimate upside in this, you’d better have a vehicle, or the actual physical gold, where you actually have it. Because the last thing you want is to be settled in cash at a time when that gold is the best asset you can own, and that’s what I’ve been telling people for a long time. Be real sure that the gold asset you have is the Real McCoy.
David: John, the last couple of months I’ve been taking physical delivery or 100-ounce bars, Royal Canadian mint silver bars, and gold kilo bars. You guys make the finest bars on the planet. I think, like the iPhone was to the world of telephony was 5-6 years ago – you just looked at it and said, “Now that’s a slick product,” – I look at the RCM bars and they capture the imagination. They’re beautiful. Unfortunately, I now have to wait four weeks for delivery.
John: There’s no surprise in that.
David: (laughter) You’re close to the source, maybe you don’t have to wait.
John: No, we do. The fact is, there is more demand than there is supply, and the refiners are going full out. This is the tell on the fact that there just isn’t enough physical gold around and they are trying one last paper cleanout to basically get the price down, so I think some of the bullion banks can reverse their positions and get from short to long. When that is completed, I think the thing is going to be released to the upside and it’s going to be really something to behold.
David: Let’s fast forward, say, five years from now, and maybe it’s only two or three, but bull markets tend to move in stages, and from their infancy to maturity, you tend to see something that sort of accelerates in terms of a rate of change. As you get toward the end, the rate of change continues to increase, typically.
As and when we get to the end of a bull market in precious metals, still probably a few years ahead of us, in your opinion what is next? Because the challenge is, in that environment, the circumstances that drive the price of gold to those peak levels really do remake the financial landscape. Where would you go, if you were going on a shopping spree, hypothetically, three years out, five years out?
John: At the end, after the gold price has reflected reality, what would I do?
David: Yes.
John: I think what will happen, and smarter guys than me have made this suggestion, is that I think gold will be reintroduced into the financial system to back currencies, perhaps a different reserve currency, because so much confidence will have been lost in them. At that point, you could certainly move on from your gold, because at that point it will be part of the system, and you are going to have to analyze the overall system. I still think real assets need to be – a great business to me would be something I’d rather own at that point than holding my gold, which at that point, basically, reflected its value.
David: There was a conference in Genoa, not the one in 1922 where we went from the gold to the gold exchange standard, but another one in the late 1960s, and there was a discussion of revaluing the price of gold from $35 to some higher price. This was a conference of central bankers, and prominently in their discussion was the idea that speculators cannot be rewarded. If we’re going to peg the price of gold at a higher number, we have to make sure that speculators aren’t the ones that are the primary beneficiaries. How do you navigate these waters if we have gold coming into the financial system again, perhaps it’s pegged at a higher price, maybe that’s $2,000, $5,000, $10,000, who knows how much per ounce?
John: A smarter guy than me suggests $7,000, so anything is possible. But your question is a good one, because I think there is probably going to be some excess profit tax applied to the gold that you hold if they were to do that.
David: Again, how do you navigate these waters?
John: I still think it’s the best thing to own relative to what could happen to a lot of these paper assets as this whole thing comes unstuck.
David: Maybe the reverse side of the equation you suggested earlier, when you said if you are looking at mining shares today, you begin the process of acquisition at lower prices, and maybe you pay a higher price today, a lower price tomorrow, or a higher price today, and an even higher price tomorrow, but you are averaging your cost per share today. Maybe that’s the same approach you take with physical metals, as well. You average out, just as you have averaged in, and assume that if an excess profit tax comes in that it is less relevant to you because you have been diligent and disciplined in an exit strategy, just as you would be in an acquisition strategy.
John: Good point. I think if you also have a mix in your portfolio of gold and silver bullion, and the shares – think about that. If they revalue gold at a dramatically higher level, these companies would make a fortune, and right now they are being valued as if gold is going to $1,000. So I think the shares offer a really interesting opportunity under that scenario.
David: I remember the City Research Group was basically saying $2400, $2500 gold, as we were hitting the September interim peaks of 1920, and now the same group is saying $770 on the gold price. It seems to me that they suffer from the same sort of psychological swings from greed to fear, and are unable to separate out data from feeling. Where do you see the price going? Certainly not $770? (laughter) I hope not.
John: Well, I think right now most mining companies are probably losing cash money at these prices, certainly in the silver market they are, if they are a pure silver producer. And I think that this will bottom within the next month. It could take one hit to the downside, given that it has gone a lot further to the downside than a rational mind would have ever thought, so who knows what they can do in the very short term. But I would say by the end of the year, you might be challenging the all-time high. I’m less worried about the downside, as long as you’re paying for it and you’re not levered, than missing the opportunity. I’d rather be a month too early than five minutes too late.
David: That’s a critical point. Well, with the wisdom you’ve gained and earned through the years of experience you have, what would you say? If this was a dinner discussion with your family members, your daughter, for instance, what advice would you give, given the circumstances we’re in, knowing that it might be the last bit of advice you say? “Here are the things you must focus on.”
John: I think the key thing to focus on is the fact that very few people own any gold or silver in their portfolios. I think, collectively, if you added up all the gold and silver and gold and silver shares, they would be less than 1% of assets today. In a bull market, they get as high as 10%, and the fact that they are under-owned and sentiment is terrible, this is an incredible opportunity, and you must have some in your portfolio. You can choose your percentage, but zero is not an option anymore, in my opinion, because there is considerable risk in the financial asset side, so I think you have to diversify into the metals at these remarkably cheap prices.
David: We appreciate you joining us again, and look forward to seeing you again in Toronto, hopefully, not too far from now.
John: Yes, anytime. Just give me a shout, and we can get together, and bring your son again.
David: We’ll look forward to that. I know he had a good time.
John: Yes, I thought it was fun, too.
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Kevin: Well, for any gold investor listening to John and you, David, it’s got to be encouraging, like I was saying, because we’ve seen so much downside, but it’s been manipulated and we know it’s not true, based on supply and demand. Just looking at the numbers, John really feels good about this fall, going into the next year, on the precious metals market.
David: Yes, sitting at lunch with him, and my son and I sitting there and talking with him, it was a great conversation, an amazingly down-to-earth guy, but with an acumen, and a recall, and an insight into the markets which is second to none. I really enjoy having him on the commentary.
Yes, it is encouraging to know that you are not a lone voice in the context of the long-term gold and silver precious metals bull market, but the trend that’s been in place since 2000-2001 has yet to end. And that, I think, is a critical point to recall, that these counter-, or contra-cyclical, trends, yes we’ve had corrections, yes we had them in 2005, yes we had them in 2008, we’ve had two in addition to that. In this long-term secular bull market there have been cyclical bears which have taken the price down, and those prices have recovered, put in new highs.
We would concur. Is it this year? Or 2014? That might be the only difference of opinion, but we’re now slicing and dicing between a December 31st date, and maybe mid-year next year, where we take out the old highs of 1920, but take out those highs, we will.
