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Gold Volatility Coming from "Summer Lull, Not Deflation"

Why current gold market volatility is not caused by deflation, but by seasonal factors...

A SPEAKER at major resource conferences, including the Cambridge House resource conference series, John Lee CFA has gained invaluable insights by living in three continents and making frequent globe-spanning visits to Gold Mining and other mineral sites.

Founded in 2004, John Lee's Mau Capital Management hedge fund is based in Vancouver and invests mostly in junior mining companies. Here he speaks with The Gold Report, John Lee deflates the deflation argument, discusses why he favors near-term gold and silver producers over early stage explorers, and reveals some of his fund's top holdings.

The Gold Report: Everyone is concerned with the volatility in the markets. What's going on out there?

John Lee: Well, there's the proverbial "sell in May and walk away" going on, even though commodity prices have stayed fairly buoyant. In the junior market, there's a lot of paper that came out and began trading from the financings conducted in November and December. I think we're experiencing a little bit of a weak season where equity markets are vulnerable.

TGR: I was reading some of your presentations and one thing that you talk about is paper currencies being at the mercy of government and you consider gold a hedge against paper. On July 1st, one of the more popular gold futures contracts lost $40, its biggest drop since February. Investors seem to be gravitating toward T-bills because they fear deflation. Should we fear gold's prospects in a deflationary economic environment or should we expect Gold Prices ultimately to continue their record bull run?

John Lee: Well, you touched on a number of issues there. July 1 was Canada Day and Canadian markets were closed and you had the futures markets trading. There is actually some evidence to suggest that the markets, on a given Friday or the day before a holiday, will see a heavy correction—a one-day correction. However, Gold Prices are around $1,211 right now (July 2). It's only $50 from its all-time high. And so, the market is really healthy.

In terms of the discussion of inflation and deflation, I am firmly in the inflationary camp. In the history of fiat currency, there has never been a scenario where deflation has occurred. You have to adhere to the real definition of deflation, which is a decrease in money supply. The money supply is, in the history of fiat currencies, always on the way up, not on the way down. There may be brief periods when the increase in money supply slows, but rest assured that the money supply is still increasing. With deflation we're talking about an actual decrease in the money supply.

I think it's almost nonsense to become concerned about deflation. Going back to the Great Depression of the 1930s, the reason we had a deflationary scare was because the Gold Price was tied to the Dollar. But this time it is not tied to the Dollar. So in a true deflationary scenario, gold's purchasing power will go down because the paper currencies' purchasing power is going up. But this is not what we have today.

TGR: Right, but people like T-Bills because if you buy a $100 T-bill and you cash it out a year later or even three months later, it is still going to be worth at least the original $100. They're safe. Should people be buying T-bills, gold bullion or shares in gold companies as a hedge against what's happening right now in financial markets?

John Lee: You should have bonds and equities and in cash. Then you can break it down further: the equities into international equities and domestic equities; the cash, into precious metals and currencies. Also, you should really allocate a basket of commodities, and get some real estate as well. Depending on your risk tolerance, you may structure your portfolio differently. There is a place obviously for T-bills in the cash category. I think in terms of Gold Bullion and precious metals, it's money so it belongs to the same category as T-bills. And it's not necessarily a good idea to put all your T-bills in US Dollars.

I think in a reasonable portfolio you should have about 30% cash, which is a prudent way to go. I would say 10% in foreign currencies, 10% in US Dollars, and 10% in precious metals. It depends on which country you live in, because I think a number of currencies trend together.

TGR: Is there anything that you put faith in when it comes to monitoring global economic conditions? Charts? LIBOR rates?

John Lee: Usually commodity prices are a good indicator or forecast of what is to come, and so are equity markets, particularly the emerging equity markets such as Brazil, Shanghai and Hong Kong. What they're telling me is it's a pretty mixed picture, but I would say growth in commodity prices such as copper and oil, and growth in emerging equity markets are good signs. You talked about the bond prices; usually, if bonds and equities both go down together, that is a signal of something severe that could be coming into place. But right now the bond markets are still staying fairly stable, even though the equity markets have corrected somewhat from earlier this year.

It looks to me now like there is some profit-taking, given that all the major indices, including the Canadian TSX and S&P and the Asian markets, have racked up over a 50% gain since their low in March 2009.

Another gauge is the Baltic Shipping Index. It tells you the global shipping activities from everywhere else are pretty much gravitating toward Asia and China. Since the financial crisis (in 2008) it has recouped a lot of its losses; however, it's gone down the other way quite severely; 30%–40% in the last 30 days.

I think it's a mixed picture. Nobody really knows what's going on. Even within Asia there are mixed pictures between, say, Korea, Taiwan, Thailand and China. Only in China are things going on all cylinders.

TGR: Really? I think Hong Kong's Hang Seng Index is down about 20% so far this year.

John Lee: Yes, and the Shanghai is down more than that.

TGR: So if China is going on all cylinders, shouldn't those markets be performing better?

John Lee: In the short run, there is obviously a disconnect between the equity markets and the economy. Although a lot of times the equity markets are forecasting what's going to happen, you can't read so much into the markets as they go up 10% and down 10% on a monthly basis. Keep in mind, China is very centralized; it's not a free economy. The government has $2.2–$2.5 trillion in their coffers so they can easily weather any sort of a storm and dictate the pace of progress. For example, they're spending around $1 trillion building high-speed railways; in three years time they're going to have more high-speed rails than the rest of the world combined. Any short-term corrections are not going to dissuade them from their plans. And they're building buildings, a lot of them. Their low occupancy rate is not going to stop them from trying to deploy as much of their $2 trillion as they can before the Dollars go bad.

It's the first time since the 1960s that the dividend yields are lower than the interest rates. So, basically you have this giant casino going on; you have money coming in, going out; and you have the Greek situation and the Spanish situation. Every time the US market rebounds, they're crediting that to Chinese growth, and every time you have an equity correction it's going back to China again. China has already surpassed the United States in both automobile purchases and auto production. Their rate of auto consumption is growing somewhere around 50% annually.

TGR: What did you think of today's job numbers out of the US? 83,000 jobs added.

John Lee: Some people will tell you they're suspicious of the numbers and the way the numbers are calculated. If you look at the foreclosure rate, it's in the range of 15%–25%, depending on the region of the country. I think that's probably a better indicator of the employment rate than the government's stated numbers. Even though the official unemployment rate is 9.5%, the real numbers could be twice as much, depending on how you define that.

The US economy is no longer the world's largest consumer of commodities; they're no longer the world's largest auto purchaser; they constitute 6% of the world's population. At the same time, they're not even the main influence on the US equity market, given that S&P 500 companies derive somewhere around 50% of their revenues and profits from outside the US

TGR: But you're still a big believer in junior mining companies, correct?

John Lee: Yes, I am. That's my specialty.

TGR: Can you talk about some of your favorite names among the junior miners?

John Lee: Yes, but first I would like to talk about the junior market scene. For example, on the TSX Venture Exchange, about 70%–80% of the companies listed are mining related in one way or another. It went from c$600–C$700 in 2001 to a high of C$3,300 in 2008, so that's about a 500% increase. In December 2008, it was down to C$700, and now it's back to about C$1,400. It's still less than half of what the peak was, and I think there's a lot of people who say, "You know what? If gold prices are $50 down from an all-time high, and copper is not that far from its all-time peak either—copper went from $0.70 in 2001 to $4 in early 2008, and now is trading around $2.80—then surely the juniors will have to follow, if not exceed its previous high of C$3,300." It would make sense because commodity prices have resumed their bull run.

TGR: What do you look for in a junior?

John Lee: I would not be so much focusing on value because a lot of management has lost a lot of their traditional means of financing. I mean it used to be that you could just walk down a Vancouver street and get broker financing at a 20% discount (to market price). It doesn't work that way anymore; the model has broken down. So, you have a lot of companies that are sitting on very good assets, but the management doesn't have the energy to go to unconventional financing sources such as the Chinese, the Middle East or the Europeans.

Therefore, I tend to focus on companies with a higher market cap and—I can't believe what's coming out of my mouth right now—the companies that are trading at a slight premium. Those companies are on the path of becoming a producer. What I am trying to say is that the gap between a producer and an explorer is widening, and I don't see that trend changing anytime soon.

More than ever you've got to be really selective on the junior market. There is not a lot of stupid money around chasing promotional stories, and when there is, instead of driving it much higher, it's barely a blip on the radar screen. I would say that with the junior market today you've got really to be cautious and look for stories that will be in production in the near term. Or gold exploration companies that have legitimate ounces in the ground.

I am not so much into drill plays because these near-term producers are still selling at extreme discounts. You don't really have to go down that far in the food chain to gain leverage.

TGR: But what do you define as a good asset?

John Lee: A good asset is one that has a reasonable time line and road map into production. I would not be so much into a gold deposit way out there in, say Nunavut, that has tens of millions of ounces or tens of billions of pounds. I am more into where you have a modest size, say 1–2 million ounces, in a good jurisdiction, and also you have to look for management that has a history—proven history—of an ability to raise money. Ideally, the company is aligned with one of the big backers, whether it's Lukas Lundin or Ross Beaty or Hunter Dickinson; you really have to identify a company with a good management group that can raise money. And with a deposit that doesn't require billions of Dollars for infrastructure because, like I said, money is very hard to come by now.

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