Almost all investors, including most investors who listen to us who are inclined to like the gold story, are still under-invested in gold.
Recorded: March 31, 2020
INTERVIEW TRANSCRIPT (EDITED)
Albert Lu: Rick, thanks for joining me here on Sprott Media.
Rick Rule: Albert, thank you for producing these. I’ve gotten wonderful feedback from clients and other people in the Sprott universe about the great job you’re doing with all the information products that you are putting out.
AL: I appreciate that, Rick. Last week we promised viewers that we would do a deep dive into gold and silver this week. I want to deliver on the first half of this promise and discuss gold with you.
RR: Let’s frame the discussion in two parts. First of all, gold the commodity, the physical, and, then later, the gold securities, if that’s okay.
AL: That’s fine and the other thing I want to lay out before we begin is from which vantage point will you be discussing these topics: Rick Rule the investor or Rick Rule the speculator?
RR: I think to begin with Rick Rule the investor. I think that one invests before one speculates and we’ll talk about why that’s important later in the discussion. Okay, let’s start with gold itself. I think it’s important to say now that the wind is very likely in gold’s sails. That is, that the macro set of circumstances strongly favors gold. I probably had 50 questions in the last four weeks as to why gold didn’t respond more dramatically to the liquidity crisis, so let’s address that first. Gold did respond to the liquidity crisis — people who owned gold had liquidity and their liquidity was called on. They had to sell what had a bid, and that included gold, to add to the liquidity.
The Sprott trading desk, which, as you know, Albert, is very active in the physical bullion market, heard from their own sources that as much as $60B worth of gold was held in leveraged-long commodity trading accounts, [with] some of these accounts leveraged as much as 33:1. When credit dried up overnight that gold had to go to gold heaven to extinguish the credit. And, on top of that, gold held in other leveraged, even general securities, accounts often had to be sold to meet margin debt. So the truth is that gold’s deep liquidity served the buyers in times of crisis as it always does.
It’s important to note, Albert, that if you look back at past liquidity squeezes — by this I’m thinking about primarily 2008, but also 2000, 1987 and 1988 — that the crisis itself, the panic [and] liquidity crisis, didn’t drive the price of gold because gold [was] sold off to meet the needs of liquidity. What drove the gold price subsequently was the policy response to the liquidity crisis. The big thinkers of the world, the central banks, the legislators, those kinds of people, always seemed to deal with liquidity-driven crises with three things: spending stimulus, quantitative easing, which as you know I refer to as counterfeiting, and, of course, artificial lowering of interest rates. It’s that triumvirate — spending money we don’t have on things we don’t need, conjuring money out of thin air and artificially reducing the compensation for saving — that moves the gold price. The most important determinant in my career of the gold price — I’m not trying to say that there haven’t been geopolitical events or other things moving the price of gold — but the thing that’s moved the price of gold mostly in my career has been faith, or lack of faith, in the ongoing purchasing power of the U.S. dollar, most importantly the U.S. dollar expressed by the U.S. 10-year Treasury.
So let’s look at the factors behind it, which we’ve done before, but let’s summarize them. The first is that quantitative easing, which is adding to the stock of currency with no basis. This isn’t borrowing. This is conjuring currency [which] must, by itself, debase the currency. You’re increasing the float without increasing the value. The second is that the on-balance sheet operations, which is to say the borrowing, adds to an already precarious debt situation facing the U.S. government. We’ve done these numbers before but let’s do them again. They bear repeating. At the federal level, $23T in recourse liabilities, $18T net of the balance sheet of the Fed and over $100T in off-balance sheet liabilities. That means simply, at the federal level, Albert, the U.S. government, which is to say indirectly unfortunately us, have $120T in liabilities. It’s important to note that these don’t include state liabilities or local liabilities, nor do they include the underfunded pension funds at the public and private levels. Now this debt number is ugly in isolation, but you need to look at the debt number relative to our ability to service it. You service this $120T in liabilities with, of course, the national income taxes and fees less expenses. The problem is that the number is upside-down, meaning it’s negative to the tune of $1.5T. It is, as you know, impossible to derive a positive sum by adding a column of negative numbers and it would appear that the deficit goes on ad nauseam.
So the top of the equation, that is to say the credit quality of the borrower, is I think very much in question. How do we get out of this? Well, either a good old-fashioned default — it seems politically unlikely to me — or further debasement of the currency, which is to say further erosion of the purchasing power of your savings, and the quantitative easing, of course, goes on. Any of our listeners who paid any attention to the Christmas tree legislation last week, by Christmas tree I mean the $2T in stimulus that awarded a reward to every politically connected constituency in the country, whether or not they happen to have the coronavirus, is ample evidence of what fiscal action is all about in the face of a crisis. Every politically favored constituency got a handout. The people who need it, of course, got very little because they don’t have very much clout. Today, of course, Trump announced phase 2 which is a $2T infrastructure stimulus bill. Governments are famous for allocating infrastructure investments to politically favored constituencies, so I would suggest to you but one thing: What the coronavirus has spawned is $4T in additional expenditure with very little probable long-term benefit. So I think that is pretty clear that, firstly, the debasement of the currency as a consequence of quantitative easing or counterfeiting is occurring. The second thing that’s occurring is that we’re incurring recourse liabilities, and probably non-recourse liabilities, very, very quickly as well, which means that the debit side of our balance sheet is increasing at the same time that our ability to service it is decreasing. Finally, of course, there is the reward for savings. Who’s going to buy these bonds?
The U.S. 10-year Treasury, as I look at it today, is paying about 60 basis points — six-tenths of 1%. The CPI stated rate of inflation is 1.6%, meaning that the government is telling you that the value of your savings held in U.S. Savings bonds declines by 1% a year for the next 10 years. To reiterate, our mutual friend Jim Grant calls this return free risk. This conjunction of factors — the debasement of the currency, the deteriorating balance sheet and the extraordinarily low [return] to investors for assuming risk to their purchasing power — I think can only be good for gold. When? I don’t know. Again, looking at past crises, it often takes three months or four months for the effect, or the anticipation of the effect, of the policy response to a crisis to impact the gold price. It’s worthy to note, Albert, that you and I are not the only ones who have noticed this phenomenon. At the retail level across the United States, retail physical products, small denomination gold products like 1 oz. gold products or 100 gram gold products coins or small denominations silver products, are either sold out of retail dealers or only are available with astonishing premiums, to the extent where I heard today that there are several one ounce gold premiums that are selling for $2,200 in the face of the spot market, which is much below that.
So what I’m suggesting to you is that the anticipation of the fiscal response to the liquidity crisis is already such that people are beginning to diversify their savings to include, of course, gold.
AL: Rick, I understand the temptation to go out and get gold now, and that is, I believe, the correct thing to do if you’re not adequately diversified but, really, the smart place to be would have been to have listened to Rick Rule months or years ago, to have listened to Ray Dalio, Jim Grant, Doug Casey, even Jim Cramer, allocating 10, 15, 20% of your portfolio to gold and for the people who had metaphorical fires in their portfolio due to margin calls, the liquidity of gold would have been very helpful in putting out that fire. What about people who weren’t suffering from margin calls? I think many of us tend to look at gold priced in U.S. dollars, which is a very important metric but not the only metric. You could have looked at gold as priced in Dow Jones stocks, or other stocks, or other income generating things. If you look at it in those terms, gold did respond very well. It’s responded well in terms of the dollar, with six straight quarterly gains, but in terms of other assets, it’s really done well. Should people be looking at maybe moving out of gold to take advantage of some of these opportunities in, you know, productive assets?
RR: My belief, Albert, is that almost all investors, including most investors who listen to us who are inclined to like the gold story, are still under-invested in gold. I say this for two reasons. A major bank study, which I read, and I’ve quoted it before in interviews with you, says that between 0.3%-0.5% of savings and investment assets in the United States involve precious metals or precious metals securities. That may have gone up because the denominator has declined the value, the Dow is an example, but the three decade-long mean was between 1.5%-2%. So gold is still very broadly under-owned, and I would suggest it’s even under-owned among people who are listening to this broadcast. Now, the second thing is that when you have a circumstance where confidence is compromised, the gold tends to not move 10% or 15% — you’ll remember the early part of the decade that was 2000 to 2010 gold began that decade at $252 an ounce if my memory serves me well and ended the decade closer to $1,900.
When gold moves it tends to really, really move, so yes, the gold price in U.S. dollars has moved from what? $1,100 to $1600. The gold price in Canadian dollars, Australian dollars, euro, yen, yuan has moved even more. The truth is that the circumstances that would cause a rational investor to own gold are very much intact and we are very much in the early days. Does this ignore buying productive investments? Of course not. Gold moves so well that a little bit of it in your portfolio generates a whole bunch of portfolio insurance. But by way of a little bit I mean somewhere between 3% and 10% of your portfolio. I would suggest that most of the people listening to this broadcast have 1% or 2% of their portfolio in precious metals, even today. Others among you, and you will know who you are, have adequate amounts of gold in your portfolio. Congratulations. I’m sure you don’t need my congratulations; you are already smiling. The truth is, for two reasons, the macro circumstance and also the extraordinary performance of gold when it performs, I would suggest that it isn’t too early to buy now.
What’s important, irrespective of the form that your precious metals ownership comes in, [is] that you have some precious metals in your portfolio to shelter you against the policy responses that we see from the current economic circumstance.
AL: Rick, one of the ways the market has changed since that epic run we had in gold, that began roughly in 2002, is that the policy response happens almost coincidentally with the crisis. So the Federal Reserve and the Treasury are very quick to act now, unprecedented. Danielle DiMartino Booth said the other day we had 5 years’ worth of policy action just in a couple press conferences. So that would suggest that we’re not going to have as much time to position in gold to benefit from the run that we expect will be coming as a result of the policy?
RR: That’s an excellent observation, Albert, and one that I hadn’t thought of it before. I certainly never think of the political class as being efficient, but when you think of their efficiency in terms of using broad panic to change the way we live — I’m being polite — they’re extremely efficient. Quoting Rahm Emanuel, who was of course the Obama advisor, “Never let a good crisis go to waste.” Certainly the policy response that we’ve seen, the $2T stimulus package last week, [is] a wonderful excuse to aid politically favored constituencies. And the $2T announced today would suggest that what you say is very true. The policy responses are bipartisan. The first thing that Democrats and Republicans have been able to agree on during the whole of the Trump administration is that they could agree that they could use the crisis to appropriate $2T to aid their allies and they did that very, very efficiently. I suspect that what you’re saying is true and it might be that the response of the precious metals to policies will be accelerated too because, as you say, the policy response is coming much more quickly than it has in prior crises.
I remember, and I even forget what the crisis was, a sort of a putative crisis in the Clinton administration, before Mr. Clinton learned that he didn’t have to borrow, he could just print, and he talked about the most powerful first force on Earth being the bond vigilantes. There was some discussion that the United States would give a Treasury auction and no one would come. Well, the Democrats and the Republicans don’t worry about that anymore. They don’t sell bonds. They buy them, and they don’t buy them with savings. They buy them with the freshly created specie.
So they have learned to be extremely, extremely efficient in the policy response. And I take your suggestion with some interest.
AL: Let’s shift the discussion to gold equities now, Rick. The same case that you make for gold, it trickles up to the gold equities. But how are they different and how would you approach them from an investment point of view?
RR: As they are different we’re going to delve into a little history here because in my career gold has moved and then the gold stocks have moved and the gold stocks have moved because, first of all, the gold stock buyer is less of an insurance buyer. The gold buyer was an insurance buyer. The gold stock buyer is looking for out-performance in a company and it has been my experience that the gold stocks move after the increase in the gold price has been reflected in the income statement and the balance sheet of the individual companies.
What happens historically is that the biggest and best of the gold stocks move first. Then, the second tiers move as people go down the quality trail. And then lastly, the junior producers and the juniors move the last, but they move in fact the farthest. It’s important to know though that the gold stocks move in response to gold and gold moves in response to policy. So the period, the distance in time, which as you point out, may now be compressed but the distance in time before the crisis and the move in the gold equities historically has been six to nine months, because the increase in the gold price has to show up in the income statement of the gold producers.
It’s important too, Albert, — you didn’t ask me this question but I’m going to use your questions [as] a platform for a statement — that the strong U.S. dollar relative to other currencies is an important consideration in the gold equities. If a gold company is producing gold in Australia or Canada with declining currencies, what it means is that the costs of those operations are declining in U.S. dollar terms. The company’s inputs are declining at the same time that the price that they’re receiving for their product is increasing, which is great on margins. Secondly, this is also important, usually one of the top three most important inputs in a goldmine is energy, fuel as an example, and the incredible low prices that we’re seeing for oil and the increasingly low prices that we’re seeing for refined petroleum products, and also other forms of energy, lower the input costs for gold miners.
So I would suspect that the impact of the increasing gold price will have on the income statements of gold mining companies will be particularly impressive for companies who produce outside of the United States where their costs are declining as a function both of energy prices but also declining currencies like the Australian dollar and the Canadian dollar.
AL: Rick, two questions related to energy actually because I was going to ask you that before you mentioned it. Is there anything in place, hedges or things like that, that will prevent the lower energy prices from showing up on the income statements anytime soon?
RR: There may well be gold producers who locked in energy prices for fear of energy price increases that now will show losses on hedge books. I’m not familiar with that. Certainly, there are a reasonable number of gold producers who looked at the increase in the gold price pre-COVID-19 who had hedged gold production to lock in what they thought might be high gold prices. And those companies, while those hedges are in place, will not benefit as much as they would have had they been unhedged. But the truth is that the magnitude of the gold price increase and the magnitude of what I believe will be the gold price increases to follow will be such that the industry as a whole will shake off the hedges without too much damage to either the income statement or the balance sheet.
AL: Rick, when you’re shopping for mining companies do you prefer mining companies that are exposed to the markets — unhedged to energy, unhedged to currency, unhedged to the gold price?
RR: That depends on for who, Albert. The most important consideration for me, for most investors right now, is simply to buy the best of the best. We’ve talked about this in prior interviews that you and I have done, particularly that interview with the gold mining index chart, which we could of course make available to anybody who wants it. The magnitude of the increase in gold mining equity prices during recoveries from oversold bottoms like this it’s so extraordinary, if my memory serves me well 150% to 1,200% over periods of time as brief as 17 months or as long as 42 months, that you don’t have to get too cute. Buy the best of the best even though, ironically, the best of the best underperform the index over the course of the market, they outperform early on and they give you most of the market performance but with much less risk. More sophisticated strategies come around understanding gold companies well enough to understand those companies that will have production increases over the next three to five years or offer the most leverage.
To go looking for companies that offer the most leverage for gold involves, paradoxically, having the courage to own the high-cost producers whose operating margins increase the most when the gold price increases and finding those companies that had the courage, or some would say the foolishness, not to lock in prices that they thought were high prices. So, certainly, the unhedged producers generate the most speculative appeal.
What I would ask our listeners to do right now, the ones who don’t own much gold or gold equities, is buy some gold [and] pray that the price doesn’t go up because the circumstance that leads to vastly higher gold prices is invariably hard on the rest of your portfolio. After you’ve done that, position yourself in the gold equities, the best of the best gold equities — a teaser if you don’t know what the best of the best gold equities are, call your Sprott Global broker and if you don’t have one, get one. I think it’s important to your financial future.
AL: Rick, I’ve got a follow-up question regarding energy. I understand the argument that foreign gold producers would have the advantage in the currency, particularly as it applies to labor. What about the prospects for a U.S. producer with domestic oil production exceeding the demand and the possibility of having oil available, you know, sub-$10 a barrel domestically? Would that provide any kind of tailwind for those producers?
RR: Huge tailwind, Albert. Most American gold production is in northeast Nevada in the Battle Mountain-Carlin Trend and these are gigantic open pit operations with 400-ton haul trucks. These haul trucks’ fuel consumption is measured in gallons per mile, not miles per gallon. Gallons per mile. Similarly, remote power often relies on fossil fuel to run the mills and things like this. Oil and other forms of energy are enormous input costs in the U.S. gold production industry because the U.S. gold production industry takes place on such a massive scale. It’s not a labor-intensive business. It’s a capital- and fuel-intensive business. The tailwind that will be enjoyed by the big American producers, Newmont and Barrick in particular, as a consequence of low oil prices on their U.S. operations are difficult to overstate.
AL: Rick, that’s all I have. Do you have any parting thoughts for the viewers?
RR: Yes, I do. The truth is that many of our viewers are more sophisticated gold equities buyers. There are people that already own the best of the best. This is the time for those people to begin to look at the best of the rest. In a normal circumstance, gold moves, then the gold stocks move. Silver moves sort of concurrent with the gold stocks moving, and silver stocks move last.
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