Gold Perfect Storm
Interview with Frank Holmes
A few months ago, U.S. Global Investors' CEO and Chief Investment Officer Frank Holmes told The Gold Report readers to watch the horizon for a confluence of three forces creating the "perfect storm where gold takes off." Those forces are now in alignment, that perfect storm is raging and gold is on the move. In another exclusive interview, Frank updates us on the metal's march, its implications for gold equities, his enthusiasm for doing business in Colombia and his thoughts about the upcoming midterm U.S. elections. The Gold Report: Gold has been trading around $1,250 since the beginning of the month. You've always stated that historically the gold price increases in September. How much higher can it go based solely on traditional seasonal trends? Frank Holmes: You're basically dealing with probabilities. The only certainties are that we're going to pay taxes and we're going to die; after that it's probabilities. At U.S. Global, we try to apply our matrix of top-down macro models. We also look at cycles. You're, historically, in a festive, emotional buying season for gold at this time of year. There's a difference between the mind and the heart. The bulk of the world's gold demand is jewelry and that's for the heart. Recently, there's been more and more of the mind, which means making decisions based on currency concerns. I think when those mind and heart forces overlap, you can get these big moves. But what's much more predictable on a probability basis is a seasonal demand that picks up. September 9 was the last day of Ramadan, which is the first part of the season that you really see gold buying take place. Then we go through wedding season and the big season of lights in India, the Diwali season, then Christmas and then Chinese New Year. So we have a dual combination of demand for gold. You're seeing price makers, not the price takers, buying gold. Bangladesh just bought $400 million worth. TGR: How important do you consider that Bangladesh transaction? FH: I think that that's very significant because that's one of the poorest of the emerging countries, but it's one of the most populated. The average income is less than $200 a month. That government, which exports clothes, etc., manufactured at low cost, is taking back dollars and euros. That signals to the markets that they want to diversify foreign reserves to own gold. So I think that this is a very significant factor regarding trusting government policies when it comes to the value of their currencies. TGR: In our last interview you said, "Gold takes off when money supply and deficit spending grow while real interest rates fall below zero – that is, when the rate of inflation exceeds the nominal interest rate." Looking around the world, we see that the U.S. and European governments at the very least are engaged in fiscal policies that are both growing the money supply and increasing deficit spending. Meanwhile, real interest rates, at least in the U.S., are pretty much at zero. So it looks like the factors are in place that you say will make gold take off. FH: Gold has taken off; it's in motion. The last thing you want is for it to shoot up thousands of dollars overnight. That would be a crisis of serious magnitude. I think that we're going to see gold gradually grow in value relative to other currencies in the world for two reasons. In the first place, emerging markets have already taken it on the chin. They've had currency crises, etc. They basically have very low debt per person, very low debt as a country. They have growth rates because their government policies are for infrastructure spending, which creates sustainable jobs. And in those countries there's an emotional attachment to gold for gift-giving. So that's a key factor. But let's back up. Over the past 400 years, there have been 47 credit currency crises. That means about one every decade. When there is a currency crisis, it takes about 16 quarters to turn around. That's very long, four years. Most people confuse what we're seeing as a recession induced by rising interest rates, but those recessions last only four quarters. TGR: So we're in the midst of a currency credit crisis rather than a recession? FH: Yes. Because these crises continue for 16 quarters, we're a little more than halfway through it. I think that it's important to go back and look at these historical cycles. It's like the '30s, which is significant. China has not had such a currency disaster, but Asia did – Thailand, Indonesia, etc. in '97. It took four years; it was 2001 before they bottomed. Russia's was in '98, and they didn't bottom until about 2002, another four-year cycle. In a micro way, in America, the S&L crisis in '87 didn't bottom until '91. So this play-out takes place and there's lots of volatility. An important pattern that drives these currency issues is leverage. The number-one factor is over-borrowing by governments and citizens. That takes time to wear away, so you're going to have deflation. Governments will panic, and to get exports to create jobs, they'll devalue their currency with policies. It's basically human nature that has 400 years of data points to give you a view of this. TGR: So if we're halfway through the four-year cycle of the currency devaluation, what can we expect in the next two years? FH: My thoughts are that in the next five years gold's going to double. That means it's going to grow at a 15% compounded rate of return, which is much greater than what's expected of bonds. The next five-year bond will grow at 2%. What's interesting is that gold's volatility for the past 10 years has been less than the S&P's volatility. If it doubles in five years, we're only going to get back to 1980 inflation-adjusted prices, at still a 15% compounded rate of return. TGR: What does that mean in terms of gold stocks? FH: What that means to gold stocks is much more significant because there's an approximate leverage of almost 3-to-1. So if gold doubles, you can turn around and get three times that in gold stocks – particularly those with characteristics that we have been able to do in our regressional studies that protect shareholder value with growth in production per share or reserves per share. A real serious issue in capital markets is dilution, with gold mining companies issuing shares faster than they have gold in the ground or production increasing. TGR: Gold stocks often have volatility indexes going to 40%, so on any given day we can expect big swings. Over time should we expect this 3-to-1 ratio despite that volatility? FH: I think so. It's historical. It goes back to the '70s. Sometimes it goes down to 2.5 to 1 or 2 to 1. Sometimes it goes up to 4 to 1. But it averages around 3 to 1. The big-cap gold stocks that have this huge leverage typically work in South Africa. The reason for that greater leverage is a combination of currency swings along with the changes in price of gold. They can have a significant impact on the cash flow of these gold mining companies. TGR: So if the general ratio is 3-to-1 in terms of gold stocks relative to the underlying commodity, wouldn't it be a good play just to buy into a gold index? FH: I think it's helpful to diversify. We've advocated that investors consider having 5% in bullion or buy the one you love lots of high-quality gold jewelry. This is contrary to all those TV pitches saying, "Sell me your gold." We also suggest investing 5% in unhedged gold stocks. TGR: Your Gold and Precious Metals Fund is outperforming its comparative index, which is the FTSE Gold Mines Index. What has caused your fund to outperform its general market basket? FH: As I mentioned earlier, we use a set of matrices that are top-down macro models. But we also use a bottom-up micro stock-selection model to determine weightings in a certain commodity. It could be gold or overweighting silver, etc., and silver has a higher volatility beta than gold. So in a rising market, we will see a greater exposure on silver holdings as we rotate into them. I think it's this capacity of using disciplined macro models to overweight the commodity-based securities, and even sometimes countries. Back in 2003, the best performing gold stocks were big-cap South Africans. The price of gold went from $250 to $325 and these stocks went up 120%. The following year gold went to $400. These stocks were laggards – dramatically. There's no performance. Why? Because their currency went up faster during that period and wiped out all their cash flow, whereas Latin American gold mining company producers exploded with that rise of gold over $400. So one has
to look at the currencies of where the company is producing its
gold and one has to look at what we like to call GARP, or basic
"growth at a reasonable price," in our stock selection
model. As I indicated, we focus on historical and social economic
cycles, applying both statistical and fundamental models, including
GARP, to identify those companies with superior metrics. September 22, 2010 Copyright © 2010 Market Oracle
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