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Bond Vigilantes Ultimately Good for Gold

Commodities / Gold and Silver 2011 Feb 04, 2011 - 02:41 PM GMT

By: The_Gold_Report


Best Financial Markets Analysis ArticleAddicted to Profits Editor David Skarica predicts that in the second half of 2011, Europe's "bond vigilantes" will make their presence felt in the U.S. by driving up interest rates and driving down the dollar. That's one of the reasons he remains bullish on gold. "I think we're going to see gold headed much, much higher," David says in this exclusive interview with The Gold Report. To learn about David's investment thesis for the gold market and a few names that offer better value post correction, read on.

The Gold Report: Hi David, welcome back to The Gold Report.

David Skarica: It's good to be here. Thank you for having me back.

TGR: You're quite welcome. You tend to look at macroeconomic trends and draw conclusions based on your observations. What are you observing in the gold market that has led to about a 6% drop in January?

DS: I think there are just two factors for me. First, gold was overbought. When gold topped in early December, we were far above the 200- or 150-day moving averages. And if you get too far above these moving averages, gold tends to pull back toward them. Secondly, there are seasonal trends. Gold tends to bottom in the summer or fall and rallies at year-end; it sees another pullback early in the year (January or February) and continues the seasonal rally into the spring. For example, in 7 of the 10 years since bullion bottomed in 2001, the low for gold for the year has occurred in January or February. There's an early year pullback, and then the rally resumes afterward.

Another point I should make is that a lot of hedge funds were short the euro and long in gold, with the idea that the euro could get out of control. But then the Portuguese bond offering went well and those hedge funds had to get out of that trade, which meant they had to cover the euro short. That's why the euro rallied so quickly from $130 to $136, which is a huge move for a major currency just in a week or two. Hedge funds were also long on gold, so they had to sell. Gold stocks aren't quite as liquid or as large as the bullion market, so they fell even more. But this is a very short-term phenomenon. I don't expect it to last any longer than a month or two.

TGR: Goldman Sachs was originally predicting that gold would top in 2012 but now says it will top in 2011. Do you believe that? What advice are you giving your readers either way?

DS: In addition to my newsletter, I just published a new book, The Great Super Cycle: Profit from the Coming Inflation Tidal Wave and Dollar Devaluation. Part of the reason I wrote it was to dispel myths like those calling for a top in gold when, really, we're in the midst of a 15- to 20-year mega-super cycle for gold and gold equities. Essentially, I think we're going to see a continuation of this move higher for a number of years, caused by factors like the deficit and lack of political will to cut spending and get rid of these deficits. The current cycle started in 2001 for gold stocks, and they tend to last 15–20 years, so the cycle should continue through the 2015–2020 period.

Another reason I think Goldman is wrong is that most of the major bull gold markets tend to end when the Dow Jones Industrial Average (DJIA) to gold ratio—or how many gold ounces it takes to buy one share of the Dow—is roughly 1:1 or 2:1. With the Dow at 12,000 and gold at $1,355/oz., we're nowhere near that ratio. I think we're going to see gold headed much, much higher. With that said, I think that after the next rally we're going to see a significant pullback in gold probably in the 2012–2013 period, but that will just be a buying opportunity.

TGR: Why should we believe David Skarica over Goldman Sachs?

DS: Quite frankly, it is because I am looking at the big picture over the long term. Brokerage houses tend to make money trading the short term and only have a quarter-to-quarter outlook. There is no way Goldman Sachs is looking 5–10 years ahead; 10 years ago, I don't think Goldman was calling for $1,000/oz. gold by the end of the decade.

I am also a contrarian in gold. I have never really looked to the mainstream "big broker" teams for their opinions on gold. I have never taken them seriously because I think there is a lack of understanding of the gold market.

And, finally, I don't think gold is a trade. This cycle could spell the end of the U.S. dollar as the reserve currency of the world. I don't think that's something Goldman Sachs would predict.

TGR: That certainly would be unpopular. You said in the December issue of Addicted to Profits, "We're going to see a good old rate spike, South American-style crisis in the United States, accompanied by the twin evils: 1) Out of control inflation and 2) Currency declines." Could you talk about that pending inflation crisis and its ultimate effects?

DS: There are always fundamental underpinnings behind these cycles, but I've come to the conclusion that what is most important is the cycle itself. And interest rates run in really, really long cycles. For instance, the bond bull market lasted from 1981–2008. It was a 27-year bull market for bonds. Despite all the hoopla that bonds have done well, long-term bonds actually peaked in 2008. I think we're building a massive top in bonds here. Now, that doesn't mean we can't rally some in the short term, but within the context of building this massive secular top, the Fed is going to issue $1–$1.5 trillion of debt per year for the next five to seven years. That debt is going to put a huge amount of supply on the market and, at some point, foreign investors are going to demand a higher rate of return because they don't think the U.S. can repay its debts.

At some point, the bond vigilantes will move across the Atlantic and force rates higher. The austerity measures in Europe will probably begin to reap rewards late this year or early next year, and at that point we will probably see the UK, the Irish, and the Greek debt come down. You will see it come down from 10%–12% of GDP to 6%–7% of GDP. Whereas I don't think the U.S. is going to undertake any concrete cost-cutting measures, especially this fiscal year. If a major state has to do a debt restructuring, or if a major municipality goes into bankruptcy, that would clearly focus attention on the U.S. I think there is going to be a trigger point that turns the debt worry from Europe toward the U.S., and that would trigger bonds to go higher.

TGR: You talk about the "bond vigilantes" coming across the ocean and imposing their will on the U.S., but couldn't the Fed go into the secondary market, buy those bonds, set the rates and terms and handle it that way?

DS: At some point, the Fed loses its ability to do that. Is the Fed going to go into the day-to-day market? Sure, it could come in and buy the 30-year bonds when the options come up, but are they actually going to go into the trading market? That's the question because the day-to-day trades in the market still set long-term interest rates. So, are they going to go into the day-to-day market and start trading? The currency will be totally destroyed if that happens. I think the market has more power than the Federal Reserve. If the Fed truly had all this power, we never would have had a crisis in 2008 because it would have done everything it could to keep the Dow above 10,000 and the S&P above 1,000.

TGR: How does this fundamental weakness in the U.S. economy—and the U.S. dollar, in particular—affect gold in the long term?

DS: It's really positive for gold because gold is one of the alternatives to the U.S. dollar as the reserve currency of the world. When Fed Chairman Paul Volker fought inflation by raising interest rates in the early 1980s, we saw the stabilizing of the U.S. economy and very good economic growth in fundamentals for 20 years. There was no reason to own gold when the reserve currency was stable and the economy was booming. But when the reserve currency gets in trouble, gold simply becomes an alternative. Gold has stood the test of time. Obviously, other currencies, including the Asian currencies, benefit from this as well.

TGR: What are you telling your readers in terms of a range for the gold price in 2011?

DS: Conservatively, I have been saying $1,500–$1,600/oz. by year-end. I think at some point there will be a big spike, and that scenario plays out when the bond vigilantes move their attention to the United States and away from Europe. That's when I think you might see the big spike in gold.

The real problem for the gold price is that the mainstream public, especially in the U.S., just won't buy it. They just don't believe in it even if they're worried about what's going on. Some bank credit analyst recently said that only 1% of financial assets are in gold and gold stocks. But at a typical top in gold, that number is 5%–7%. At the bottom of the gold market, only 0.5% of financial assets were gold related. So, even with gold moving from $250/oz. to over $1,300/oz., we've seen only a 0.5% increase in the amount of total financial assets that people have in gold. For example, mainstream fund managers in the U.S. won't buy gold because they're the ones telling us it's in a bubble (even though they have never bought an ounce). The gold market is so small that when the public finally starts to accumulate gold, it could cause a big breakout. I am not just looking at a 20% rally in gold; I am looking for a 50%–60% rally that will happen over just a few months because people are finally buying it en masse.

TGR: One upside of the gold price correction that occurred in January is that it's a lot easier to find value now in the small-cap gold names. What are some companies that you're following that offer value at $1,355/oz. gold?

DS: I think the midtiers and the large caps are really the ones that have sold off. The Small Cap Index has come off the last few days, but it's held up a lot better than the large caps. And now you have very good values in the large caps. I was recently looking at Royal Gold Inc. (NASDAQ:RGLD; TSX:RGL), which is a big royalty company. With a roughly 6% or 7% drop in the price of gold, Royal Gold has dropped from $55 to $46. That looks like good value to me.

A stock like San Gold Corporation (TSX.V:SGR), which has a producing gold mine in Manitoba, has dropped from $4 –$2.76, or 32%, on this small move down in gold and no real negative news on the company. Another is New Gold Inc. (TSX:NGD; NYSE.A:NGD), which dropped from $10–$7.50, or 25%. Of course, it had a huge run before that, but those are some names I would look for.

Additionally, I would look for newer junior deals. I look for deals that have just been put together—those that are new to the market. Those companies can really move; for example, Golden Phoenix Minerals, Inc. (OTCBB:GPXM). The company has interests in a few properties, including a 20% interest in a producing mine. It trades at around $0.15 and it has a $39 million market cap. One other stock I really like is Kiska Metals Corp. (TSX.V:KSK), which is developing a big project called the Whistler Project in Alaska. Essentially, it's focusing totally on Whistler and is going to spin out its other projects. That stock dropped from $1.70–$1.10.

TGR: Yes, Kiska put out a resource estimate that somewhat disappointed the market. Do you believe the other gold deposits in that play have the potential to significantly boost the resource estimate down the road?

DS: Yes. I don't want to get too technical here, but Kiska did a lot of geophysical surveys to determine where it could expand the deposit. I would expect the fruits of that labor to come to bear this year. On top of that, the company stated that it's going to announce further resource increases from other areas of that property in the coming months. I like to buy companies like Kiska when they're small and frothy hot. I actually like consolidation from $1.70–$1.10 or so. The problem is that the market is very shortsighted. Everyone wants huge deposits, but plenty of companies that have developed huge mines have produced disappointing results along the way.

TGR: David, could you give us a couple of other small-cap names you like?

DS: I talked about Aberdeen International Inc. (TSX:AAB) the last time I was interviewed for The Gold Report. The thing I like about Aberdeen is that it has interests in numerous gold and resource companies. It had a big run from $0.35 to over $0.80, and I have been looking for it to decline into the $0.60s before I would consider purchasing it again. The net asset value (NAV) is probably in the $1.30 range, so it's still trading at a big discount to NAV. Most merchant banks or investment-type companies tend to trade right at NAV. It's really frustrating when Aberdeen's NAV is $1.30 and the stock is trading at $0.76. Although you don't want to be greedy, as an investor you ask yourself, "When is this going to finally represent the value it has in the ground?"

TGR: Could one of the problems be the company's ongoing dispute with Simmer and Jack Mines Ltd. (JSE:SIM)?

DS: To my knowledge, it has not been settled and that's got to be a big overhang on the stock. But when Aberdeen reports its NAV numbers, it does so excluding assets related to Simmer and Jack. Aberdeen just did a lot of share buybacks, as well.

TGR: Yes, CEO David Stein told me Aberdeen tries to buy back its shares whenever possible.

DS: But I would prefer it to pay a dividend to shareholders. Right now, investors are starved for income. We talked about the interest rates heading higher in the long term, but 10-year bonds are giving you only 3.5%. If Aberdeen has roughly 90 million shares outstanding, and it's paying one cent per share each quarter, you would be at about a 6% dividend; a half-cent per quarter would be a 3%–4% dividend. I think that would be much more effective for gathering shareholder interest than would share buybacks.

TGR: Maybe you should talk to David about that. Aberdeen is a Forbes and Manhattan (F&M) company; and as a merchant bank within that fold, F&M Chairman Stan Bharti uses Aberdeen to help finance other companies in the F&M stable. Aberdeen has significant positions in Sulliden Gold Corp. (TSX:SUE; OTCQX:SDDDF), Avion Gold Corp. (TSX:AVR; OTCQX:AVGCF) and Allana Potash (TSX.V:AAA), among others. You once recommended Avion Gold. What's happening with that company now?

DS: Well, Avion is probably my best recommendation ever because I got in right at the bottom in 2008–2009, but I don't know if I would be chasing that name at these levels. I know Avion is coming in with really good production and cash flow numbers and I would really like to see it consolidate here before I would even consider looking at it. Avion was $0.50 last summer.

TGR: Yes, but Avion wasn't in production in the summer.

DS: No, it wasn't in production. But we were talking about Aberdeen as a merchant bank, and part of the reason you buy Aberdeen is so you don't buy those stocks individually. It gives you nice exposure to all of them. One other Forbes & Manhattan stock that's interesting is Dacha Strategic Metals Inc. (TSX.V:DSM; OTCQX:DCHAF). I really like Dacha, but I don't like most rare earth companies because most of them are just moose pasture, right? There's nothing really there; they're just taking advantage of a hot market. What I like about Dacha is that it actually owns a lot of physical rare earths, and the long-term outlook for rare earth prices is really bullish. Dacha is an interesting way to play it; I don't think it has as much downside as some of these other rare earth names that have kind of spiked up based on nothing.

TGR: What should our readers watch for in the gold market in 2011?

DS: I am still really bullish on gold. I would be absolutely shocked if this seasonal decline we've seen, which is very similar to the decline in January/February of last year, turns outs to be anything more than just a short-term pullback.

I've been really bullish on the equity markets for the past two years. I would look for a really significant top to occur in the equity markets because of the short-term effects of the tax cuts in the U.S. and the increased economic output for a quarter or two. Then, later in the year, you're going to see pressure on the U.S. to start reining in the deficit. In the second half of 2011, I'm worried about the dollar accelerating that long-term downtrend because all the bad news out of Europe will be making its way here. We could certainly see an all-time low in the USD here in 2011.

TGR: Thanks, David. Interesting as always.

At the tender age of 18, David Skarica became the youngest person on record to pass the Canadian Securities Course. Skarica, a Canadian and British citizen, is the author of Stock Market Panic! How to Prosper in the Coming Bear Market (1998), which provided thought-provoking arguments on why a great bull market would end in the most vicious bear market of all history. He is also the author of The Contrarian Who Saved the World, which explains how markets work. His new book, The Great Super Cycle: Profit from the Coming Inflation Tidal Wave and Dollar Devaluation , will be published by John Wiley & Sons in November.

In 1998, Skarica started
Addicted to Profits, a newsletter focused on technical analysis and psychology of markets. From 2001 to 2003, ranked Addicted to Profits third out of over 300 newsletters in terms of performance. He is also the editor of Gold Stock Adviser and The International Contrarian services, which focus on gold and global investing. Dave has also been a contributing editor to Canadian MoneySaver and Investor's Digest of Canada.

Want to read more exclusive Gold Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Expert Insights page.

1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his family own the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Timmins.
3) Ian Gordon: I personally and/or my family own shares of the following companies mentioned in this interview:Timmins Gold, Golden Goliath, Millrock and Lincoln. My company, Long Wave Analytics is receiving payment from the following companies mentioned in this interview, for receiving mention on my website, Golden Goliath, Millrock and Lincoln Gold.

The GOLD Report is Copyright © 2011 by Streetwise Inc. All rights are reserved. Streetwise Inc. hereby grants an unrestricted license to use or disseminate this copyrighted material only in whole (and always including this disclaimer), but never in part. The GOLD Report does not render investment advice and does not endorse or recommend the business, products, services or securities of any company mentioned in this report. From time to time, Streetwise Inc. directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.

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