"Who am I? What am I doing here?" Those are not my words, rather the rhetorical questions pondered out-loud by a bewildered candidate named James Stockdale in his opening remarks of the 1992 vice-presidential debate against Al Gore and Dan Quayle. Ross Perot had selected his close friend, the straightforward Vice Admiral, to be his running mate on the Reform Party ticket in order to help him restore honesty and common business sense into an otherwise corrupt world of politics. Perhaps overwhelmed by the reality of being plopped onto a national, Hollywood-like stage, Stockdale delivered a dismal performance in which he came across as confused and disoriented. To be sure, as a capitalist scurrying for sensible returns while stuck in a world of government imposed zero interest rates and other interventionist policies, I can now truly empathize with the Vice Admiral’s sense of dismay.
After all, it was only two years ago that the credit implosion nearly obliterated the business of US homebuilders. Simply put, too many homes were built relative to the pool of potential buyers, and when lending evaporated, so too did the demand for new homes. Shares in the homebuilding companies, which were oversupplied with land and had insufficient access to capital to recoup their sunk costs through development, were shunned by investors, particularly because homebuilders’ primary customers—homebuyers—were also overextended. By forcing interest rates to zero, allowing the cash-strapped homebuilders a carryback provision to seek their past five years corporate income taxes paid, granting tax credits to many of those who would purchase a home, and nationalizing the deficits run up by Freddie Mac and Fannie Mae, in the face of uncertainty a country awash in homes would encourage formerly broke corporations to construct houses and would entice extended homebuyers to leverage. At least for a brief moment, the magical hand of the government had managed to do what free markets ideally seek to avoid—prop up a failed business model and pledge to fund it in perpetuity! Politicians congratulated themselves for this accomplishment, and eventually the price of homebuilding stocks soared, albeit temporarily. Can this be real? Has the world gone mad?
This surreal world morphed from an occasional, perhaps even innocent, intervention by planners into the real economy to a planned policy now characterized by a central mandate—to preserve low interest rates so that an overleveraged society can be spared the pain of adjustment. Austrian economists have long argued that interest rates are supposed to function as the signal which determines how capital is to be allocated across a market economy. As Russell Napier pointed out in a recent interview, the bond market is thought to be the most stable of all markets and serves as the cost of funds by which all other assets are priced. Unfortunately, the Fed has distorted interest rates through a variety of measures—arbitrarily dropping the already low Fed funds and discount rates, nearly tripling the size of its balance sheet, and just flatly monetizing bad debt. In a very integrated world in which foreign central governments peg or manipulate their currencies and recycle their reserves, the simple act of money printing can greatly exaggerate the direction of real interest rates. Thus, if free-market forces were to ever reassert themselves on a reckoning day, the reversal could cause immense pain. For this reason, the Fed feels compelled to keep printing and pressuring real rates lower.
Intervention Matters
While it may seem difficult to statistically prove the misallocation of capital, it is easy to recognize the circumstance that has led to some extreme imbalances. In essence, the world has "fixed" its respective currencies to an increasingly unstable US dollar--a currency backed by a dangerously excessive credit growth. The counterweight has been that the developing world has chosen to overproduce to fund the West’s excessive consumption. The equilibrium is a very fragile, unbalanced world economy. Those who insist on using only traditional economic measures tend to rationalize its existence while ignoring pragmatic observations, such as the build-up of debt and occurrence of asset bubbles.
When intervention into the free market takes place on a monumental scale, studying individual economic statistics can be very misleading. Why count the US production of homes or the Chinese production of widgets if these are unneeded products merely generated by bad policy? Thus, the study of GDP, jobs, personal income, corporate profits, trade imbalances, productivity measurements, or any other statistical measurement employed by economists can sometimes be of little relevance. Typically the examination of macroeconomics in today's regulated interest rate market is a complete waste of time; without proper consideration it might actually prove counterproductive to successful investing. In fact, if the world is predicated on a socialized interest rate model, then it should come as no surprise to find that every economy or market is potentially subject to a “flash crash” at any moment. This may explain the prevalence of what I call "Prechter’s Syndrome"—a paranoia in which seemingly rational capitalists come to believe that the entire nominal pricing mechanism will suddenly revert toward zero even though all of the long-term monetary evidence suggests that it is paper currency that will become worthless.
What many in the West fail to realize is that they are living through an asset-based stagflation: asset prices remain abnormally high relative to their earnings potential. In pursuing a low interest rate policy, it is the real economy that suffers immensely. To protect the nominal value of assets--stocks, bonds and real estate--savers are paid nearly nothing. This means little productive investment and few jobs. The "new reality" for Westerners is that, though volatile, asset prices stagnate and the average living standard falls along with the true value of fiat money.
The logic leading to the moral hazard created by today's Western money printers is very similar to the logic imposed by those advocating the continuation of slavery in the mid-1800s. Many argued that to end slavery in America would harm not only the country but that it would ultimately result in the starvation of the slaves themselves. In a similarly perverse line of logic, today's free-spending politicians and Keynesian central bankers demand that our debt-dependent economy needs low interest rates and more stimulus to grow; otherwise the entire system will implode, and every debtor will starve. Thus, for our own good, we over-indebted Americans must recognize that it is in our own best interests to expand the public sector, tax business, and print until we all become slaves of the state, beholden to our government much like today’s Greeks!
Captain Obvious: The Case against Lower Rates
The case for higher interest is clear: governments are spending too much, and central banks are printing too much; eventually these governments and their respective currencies will become subject to credit risk and/or inflation will resurface, and interest rates will rise. But what if the socialization of interest rates persists and suppresses real rates for a prolonged period? Resources then will be diverted from productive activities such as R&D and instead will be wasted on the whims of bureaucrats, voters, and crony capitalists--whims like preserving union shops such as General Motors or saving dying business models like private banks that prudently refuse to lend. While the government's strategy for success may be to dupe investors into misallocating their remaining capital into such foolish investments, the legacy of these capital diversions will be to reduce the world's optimal growth rate—not such a good outcome for those hoping to grow our way out of today’s macro imbalances.
But wait! Many governments have traditionally subsidized staple industries: In Mexico it has been tortillas, in Japan it has been rice, in China it is now production (via an undervalued exchange rate), and in America we subsidize debt through low interest rates. The point is that it is much easier to permanently subsidize something that comprises a relatively small market such as tortillas or rice, or even a large market if it produces something integral to future growth. Sadly, American debt has been used mostly to fund consumption, and the debt to GDP now exceeds a whopping 379%. Eventually, subsidizing interest rates could prove so costly that it eats up a majority of America’s production and busts the country! At that tipping point, those who recognize the opportunity and time it just right could be well served to purchase long dated put options on bonds to profit from rising rates. However, I would caution investors to avoid purchasing double inverse ETFs as a means of shorting bonds (or anything else for that matter). Unfortunately, the “hot” money rolls into these levered, double ETFs at a time when option premiums cost the most. Consequently, their NAVs are often decimated in the ensuing correction because these expensive, levered options expire worthless, and the hot money darts for the exits.
While a few might yet dispute it, central bankers’ money printing policies have contributed to a dotcom mania, a housing boom, and now may have led to a bond bubble that could end in multiple sovereign debt crises. If interventionist policies persist indefinitely, one day the Western world could actually suffer the unthinkable—a cash crash, the day on which the value of money vaporizes because, in an effort to stabilize the system, central banks are forced to expand their balance sheets not by merely the two or three times we witnessed in 2008, but by multiples of twenty to forty times! (Felix Zulauf, a Barron’s roundtable member, eloquently described that potential moment in a recent interview.). Many deflationists believe that the Fed would never compromise its integrity to such an extent because to do so would certainly spell the end of the dollar as a reserve currency and possibly lead to the demise of all paper monies.
But in the Western world entire civilizations are indebted; the masses desperately demand money and will continue pressing for what they perceive as costless debt relief while Western, Ivy-league educated central bankers will gladly accommodate them based on their own Keynesian legacies. Given these tendencies, I offer you what I believe to be an indispensable tip that should serve you well in life: rather than dwell on areas of perceived overvaluation, instead refocus your energy to identify assets that can become undervalued in a schizophrenic world of on-again off-again, turbo-charged money printing, and strike when opportunity presents.
Defensively Assessing Alternative Investments
I believe in the science of gold, which must be discovered and brought above the earth’s surface, not the religion of fiat currency whose existence is founded solely on faith. It has long been my contention that, thanks mainly to our overeducated and arrogant bankers, economists, and politicians who proselytize their failed policies, we have lived in a world of bubbles and that eventually gold will be the last bubble to inflate and then pop as the masses seek refuge in its safety. So I chose to execute on a simple formula--buy gold and go to sleep! This is not to say that gold cannot correct in price but that we are likely to continue living in an environment in which its inherent qualities are handsomely rewarded. Thus, for now I continue to believe that gold should be aggressively hoarded.
Unquestionably the safest and best way to own gold is to take physical delivery. The purpose of owning gold today is to profit from it as a store of value that is nobody else’s liability at a time when counterparty risk is very high. Not wanting to pay the hefty premiums to NAV garnered by closed end funds, many investors have embraced some of the open-end gold ETFs as a safe, liquid method of replicating the returns on gold. I also own such shares. Conspiracy types and those selling competing products have dissected the language used in these gold ETF prospectuses and surmised that some ETFs are not required to hold any physical gold. I can also tell you that it is a complete waste of time to read a prospectus that lawyers have carefully crafted and designed to be broadly interpreted. Rather, I analyze these ETFs from a businessman's perspective by fully recognizing that the contractual words mean much less than management's objectives and execution. (As an aside, I would tell you that had I always listened to my lawyer’s advice, I would have missed out on most of my lifetime opportunities as he is a true deal-killer.)
Yet these open end ETFs cannot store one hundred percent physical gold because this would result in gold perpetually being moved to and from the vault depending on the daily inflows or outflows into a fund and would prove far too costly in today’s erratic markets. Instead, open-end funds float some gold contracts in lieu of physical gold. My fear is that if the gold market ever goes parabolic, as I suspect it could, open end funds will be deluged with new capital just at a time when the physical gold market is becoming very tight. If management opts to buy paper gold with the new shares issued, this would dilute the actual physical gold held and expose shareholders to excessive counterparty risk. Further, under dire circumstances governments can become very intrusive, and the best market for gold is then the black market where safe, physical gold acts as the ultimate bearer bond. I am gradually selling my open end ETFs in favor of physical gold, sacrificing some flexibility in favor of safety.
Gold mining companies are potentially a leveraged way to play physical gold; however, the gold mining business is just that—a business—so investors should not overweight miners as a gold substitute. As many recently learned when a mining tax was proposed by the Australian government, politicians can target profitable mines because they are immovable businesses with large sunk costs. Nevertheless, now that the gold price is rising and mining costs (labor, oil, and equipment) have subsided somewhat due to the weak global economy, major miners are highly profitable. What’s critical to recognize is that it is the discounted cash flow from the potential profit per ounce of reserves that is important when valuing mining companies. Ounces in the ground can mean little if they cannot be mined profitably.
Early on in this gold bull market (2000-2003), many of the mining stocks greatly outperformed gold but then later severely underperformed (2004-2008). This is because investors had bid these share prices too far too fast—especially at a time when mining costs were rising considerably. Currently, it is some of the junior and midcap gold companies that offer the most compelling value. Essentially, gold companies are no different than traditional real estate plays in the sense that some have projects that are built-out and easy to assess while others are comprised of vacant land which is capital intensive and has uncertain returns. Paradoxically, the global capital crunch has created the opportunity to purchase small cap exploration companies with verifiable deposits at very cheap prices even while the gold price escalates.
Technicians claimed that the chart patterns of most junior and mid-cap gold equities, which had been badly lagging the majors, were forewarning of a potentially unhealthy gold market, at least for the short run. While it is true that currently there may be a strong sense of deflation in the air, throughout my life I have met very few wealthy technicians but many rich value investors, so I would use any meaningful weakness in gold as opportunity to add to my positions in well-managed gold funds like Tocqueville. I do concede, however, that the next big move up in the miners might be the last one in which investors can safely participate. After that, I’m afraid that rapacious governments will skew the risk-reward ratio in favor of owning physical gold, not mining shares, for quite a while.
Lastly, let me posit that I am correct that the gold bull will be the last bubble to burst. I have always believed that I would be able to exchange my overvalued gold for comparatively cheap Asian equities, base commodities, shares of dominant global monopolies, and certain real estate. This is because I had envisioned that government intervention would potentially cause nearly everything in the world to bust relative to gold, at least for a while. Many have made the case against overconsumption, but aren’t societies that stockpile resources and encourage overproduction also at great risk of severe contraction? If so, everything predicated on world growth stands vulnerable, yet so few seem to acknowledge the importance of a balance between consumption and production.
While I still believe the best opportunity to trade out of gold lies ahead, I must recognize that the authorities might change the rate at which they tax gold in the future, and I must at least consider the possibility that the economic purists may be wrong, that it is at least conceivable that intervention may have benefitted one part of the world (the East) at the expense of another (the West). Intervention has produced a large pool of Chinese foreign reserves which seem big compared to its nominal GDP. However, after adjusting for the purchasing power parity of the Chinese economy, these dollar reserves represent a much smaller amount of China’s true GDP. Hence, a transition to a more balanced trade with America might not be quite as awkward as some purists expect. For Asia, it certainly will be easier to retool its production capacity to meet its domestic demand than it will be for the US to continue selling its most abundant product—debt. Thus, with potentially changing rules, non-gold investments may make sense even in the context of a grand resource misallocation.
The balance of power is shifting to the East. The future of the West may more resemble the distant past--a common characteristic of countries that have pursued backward monetary, spending, and taxation policies. Investors would be well advised to gradually expose themselves to ownership in emerging markets, industrial commodities, and dominant global monopolies which are poised to grow once more sane policies are adopted (admittedly, this could be a while). In the interim these investments offer some protection against a potential monetary reckoning day. If I am wrong, at least investors will have smartly dollar cost averaged into an unleveraged basket of meaningful things that eventually should have considerable value.
The thrill of organized sport is that it can foster success through healthy, fierce and direct competition within a clearly defined set of rules. If only central bankers and politicians could follow the discipline of competitive amateur sports, not the model put forth at the professional level where corrupt players’ unions and greedy, monopolistic/monopsonistic owners change the rules or turn a blind eye while they lobby politicians for monies from the public coffers. As investors, we must recognize that rule-changing and intervention put forth at the macro level can work to confuse and disorient us even within our own local area of expertise. Therefore, we must learn to think and act outside the box yet somehow remain within the familiar circle of value investing and common sense that, over time, has spared us from dismal performance.
