An Almost Hopeless Situation

10% of US federal budget goes to servicing debt...

ADRIAN DAY, of Adrian Day Asset Management, is a British-born writer and money manager who specializes in global diversification and gold equities for individual and institutional clients.

In this interview with The Gold Report, Adrian reveals what he looks for in gold stocks, how he would fix the US federal deficit, and why his gut tells him the Gold Price is headed for a fall.

The Gold Report: Adrian, in your 2011 first quarter edition of Portfolio Review, you wrote that President Obama’s budget "shows he doesn't understand the problem or is not serious about it." How would you solve the problem?

Adrian Day: Low taxes didn't cause the problem and high taxes won't solve it. High spending caused the problem, therefore we have to tackle it by spending less. If you want to cut the deficit, you have to cut spending. If you want to cut spending, you have to go where the money is. You could eliminate every single discretionary item in the budget and hardly make a budge in the deficit. You need to cut entitlement spending — Social Security, Medicare and Medicaid — and defense.

TGR: How is the deficit problem affecting the Gold Price?

Adrian Day: It's affecting the Gold Price significantly. The US is borrowing tremendous amounts of money to meet its deficit. Over the last four to six years, China and Japan have been the largest buyers of US debt. For the last six months, China has been a seller. Japan is likely to be a seller when the latest numbers come out.

The Federal Reserve has boosted the adjusted monetary base by over 27% from January to March 2011. It's printing money to help the economy and to monetize the debt. It is buying Treasuries from the government because nobody else will. The Federal Reserve is buying over 80% of the new Treasuries being issued.

I think the situation is almost hopeless. About 10% of the federal budget is servicing debt. Since the credit crisis in 2008, the government has been doing more funding at the short end. The average yield on 30-year bonds is 2.2%. That’s extraordinarily low. On the new bonds, the average is even lower; I would venture to say well under 1%.

TGR: Standard & Poor's warned that the US would lose its credit rating should the White House and Republican Party lawmakers fail to reach a long-term solution to America's mounting debt load. Is there a way out of this that isn't good for the Gold Price?

Adrian Day: I don't think so. They can't immediately cut spending enough without putting the country into an enormous depression because so many people are dependent on government paychecks. They can't raise taxes enough. They can't raise interest rates.

The only answer is to print money and let the Dollar go. The Fed can inflate or default. I don't think they want to default. So, the Fed will continue deflating and printing money. The more that happens, the less attractive US bonds become to foreigners.

TGR: Where do you see gold stocks and the Gold Price headed?

Adrian Day: I think we're going to get meaningfully lower prices between now and the end of September. It's partly a gut feeling, partly the fact that markets don't go in straight lines for two years without corrections. We're overdue for a correction in both the Dollar and gold. I don't think a correction in gold will be long and deep. I think gold stocks are going to correct much more than gold itself.

We've had some enormous runs in gold stocks in the last year or two. When people see gold start to correct, they will be ruthless in locking in their profits. I think some of the thinly traded juniors could come up significantly. Some of them have come off dramatically—20%, 25%—just in the last month.

In addition, May is often a seasonal peak for gold. So, weakness in July and August would be more typical than not. We just need to be a little bit patient and cautious in adding to positions. But there are some good buys.

TGR: Your firm specializes in gold plays, which appreciated more than 60% last year. Isn't this a boom for you?

Adrian Day: Oh, absolutely. We're going to play it for all it's worth.

TGR: What's the typical asset mix in your gold accounts?

Adrian Day: We have gold accounts and resource accounts. In the gold accounts, we have around 25% in the seniors. We have 10% to 12% in non-gold resources, which would include silver and more diversified companies. Then we have about 35% to 40% in exploration. We have about 10% in emerging producers, second-tier companies. The rest are companies affiliated with the gold business like investment banks.

The major mining companies have a problem in that gold is a depleting asset. When a company produces an ounce of gold, it has to go out and find another ounce of gold. When you're producing 5 to 7 million ounces (Moz.) annually, it’s not that easy to find another 7 Moz. every year. That forces these companies to make acquisitions just to stay in place.

For the juniors and the exploration companies, the problem is that the odds are so long against them. The often-quoted statistic is that only 1 in 3,000 anomalies ever becomes a mine. Those are extraordinarily long odds.

TGR: But if the speculative interest in junior mining stocks were only to get to the point where the deposits were actually mined, there wouldn't be any speculative interest, right? You can still make money on stocks that never get into production.

Adrian Day: Oh, absolutely. But a company raising millions of Dollars from the market, pouring the money into holes in the ground, and not coming up with anything has to have a speculative move at some point.

It is the triumph of hope over experience that we keep giving money to companies when the odds are so long. We try to overcome that by looking at companies where the business risk is minimized or mitigated to the extent that it can be.

With seniors, for example, we're very big on royalty companies that have business plans that mitigate mining risk — companies that have plenty of upside, but don't have the same downside as producers who have the heavy curse of replacing ounces.

We very much favor the prospect-generator model where a company generates prospects and joint ventures production so other people spend the money. In return for giving away the majority of a particular property, the prospect generator retains its balance sheet. A good prospect generator can do this 5, 10, or 15 times.

TGR: You have a long-term investment philosophy.

Adrian Day: Absolutely. We buy parts of companies, not pieces of paper. I am a ruthless seller. If I change my mind on a company or the company deviates from its business plan, I look at it very carefully. But I'm also very patient in holding throughout stock price volatility.

TGR: You will be at the New York Hard Assets Investment Conference on May 9 and 10 to talk about your new book, Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks. Can you give us a preview?

Adrian Day: I'm going to talk about four long-term trends in the world. First is the shift in economic power from the US and the industrialized nations over to China and the emerging East. Second is the helpless financial situation of the US Third is the ongoing decline of the Dollar. The last is the growing shortage in resources across the board.

All four are interconnected. That's where I want to be positioned. Even in my global managed accounts, we have 40% of our assets in resources. There will be growing shortages of platinum, copper and uranium; those prices are just going higher. That is where you want to be for the next several years.

TGR: Adrian, thank you for your time and insights.

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