Reaping the Austerity Whirlwind

The outlook for gold and Silver Prices amid the crisis in Keynesian spending...

PUBLISHER of The Melman Report, Leonard Melman has been writing about gold, silver and base metals for more than two decades as monthly columnist for Prospecting and Mining Journal and Resource World Magazine.

Speaking here to The Gold Report, Melman focuses on how political and financial considerations impacting Gold Mining and the precious metals right now, plus the huge rebound he anticipates for the metals markets later this year.

The Gold Report: It seems that economists can plan and recommend, and politicians can negotiate and maneuver, and pundits can analyze and predict all they want, yet when the people don't want to play along, it can all mean nothing. Of course, we're talking about the elections in France and Greece. What's going on?

Leonard Melman: What's going on is that the monetary authorities in Europe have decided that austerity is the only way out of the financial dilemma, which I find kind of amusing, because it is their Keynesian activities that created those policies in the first place.

Their decision now is that austerity, which is cutting back government programs, is the only thing that will work. The problem is that the public doesn't want their government benefits cut back. So, the message from the French people was that Nicolas Sarkozy, with his austerity, was no longer their friend and François Hollande, with his promise to end austerity, is now the new President.

In Greece it's even more dramatic. Greece has been a funny culture for about 40 years living in a dreamland, thinking that nobody has to work and nobody has to pay taxes, which is sort of their national sport.

TGR: Not paying taxes is a national sport?

Leonard Melman: It's a high art with the people in Greece. Yet they still expect their government to give them early retirement, generous unemployment benefits, etc. That has been supported for the last 40 years by massive government borrowing. And, that's the reality after this election. The people voted out those politicians who, at least on paper, wanted to cut back the size of government. Now there could be a real crisis directly ahead of us.

TGR: Does that mean the Eurozone is going to blow up?

Leonard Melman: It's under the strongest threat since its creation 13 years ago. Greece cannot pay its debts. Because of the recent election, the monetary authorities who had been providing Greece with funds can no longer be sure that their program is going to be approved by the Greek government. If that's the case, they may suspend further payments to Greece and Greece will officially begin to default on its debt, which will be a likely cause for expulsion from the Eurozone.

If that happens, all Greek monetary matters will be restored to the previous currency unit, the Drachma. Nobody has the foggiest notion of what the Drachma will be worth because it's a totally artificial currency to begin with. We are seeing one consequence that has showed up in the market the last couple of days. Many people in Greece are getting scared and are converting their funds primarily into Euros and US Dollars.

That's one of the reasons why the Dollar has become stronger and gold and Silver Prices have become weaker. It also raises the specter of a true run on the banks, as people withdraw their Euro assets. Lying in the wings are Spain, Portugal, Italy, Ireland, Iceland, etc. In fact, there are nine Eurozone countries that are in recession. So, if the question is could the Eurozone blow up, I think it is a genuine possibility that several nations could be forced out, which would leave the Eurozone in a shambles.

TGR: With all of this bad news, neither gold nor Silver Prices seem to be responding positively. When will they be impacted by this?

Leonard Melman: For most Europeans, the US remains the financial bastion of the world. So, when Europeans look to convert assets from weakness into strength, they usually look for US government debt paper. Buying that debt paper makes the US Dollar stronger and gold and silver weaker in reflection. That will end when the US Dollar weakness begins to show itself; then we should have much more positive action in the metals.

TGR: In light of what's happened here recently, what are your expectations now for gold and Silver Prices?

Leonard Melman: The number of people who are losing, or have lost, faith in conventional politicians and economists to guide the world's affairs is growing. As that continues, I believe more and more of their assets will be turned into the precious metals as the haven of last resort. The question is when. In my annual forecast I said, and still believe, that this trend would accelerate throughout the second half of the year, creating pressure for the precious metals to rise dramatically. October, November, December, I believe, will be great months for the precious metals.

TGR: Is it going to take some great catalytic event for this to happen or will it build slowly?

Leonard Melman: The French and Greek elections could have provided that catalyst although they're talking about another election in Greece within a month. But, this has shown there's a great difference between what the politicians and economists want to do and what the public will accept.

It's like a drug addict who vows to quit because he knows the harm drugs are doing to him. Three or four days after quitting he's in the agony of withdrawal and will do anything to get more of the drugs. That's the case with several of the nations in Europe. They know the damage that excessive borrowing has done and now they're going to stop cold turkey. But, the people relying on that government borrowing don't want to lose their welfare, retirement or other government checks and they're rioting in the streets. That rioting and disillusionment is in its early stages and could get much worse. That's another reason for precious metals to go much higher. The resolution to undergo austerity is not going to be matched by the public's deeds.

TGR: So how high could gold and silver go?

Leonard Melman: The downside over the next two months could be about $1400 per ounce. During the latter part of the year, I have forecast a top in gold of about $2400 per ounce and a top in silver about $55 per ounce.

TGR: It seems like $55 per ounce is a little low on silver compared to $2400 per ounce gold. You're not a major silver bull?

Leonard Melman: I am. Let's say gold bottoms at $1400 per ounce and then goes up to $2400 per ounce. That's a gain of about 65% or 70%. If gold gets down to $1400 per ounce, silver could hit $24-25 per ounce. If it goes to $55 per ounce from $25 per ounce, that's a gain of about 120%. So, as the acceleration develops, I expect silver to go faster than gold. It's been weaker than gold, so it will take a little longer to advance. But, I have always believed that in powerful metals bull markets, silver outperforms gold on the upside, just as during declines it falls faster than gold.

TGR: So, you aren't looking for $75 per ounce silver as some people are?

Leonard Melman: Not quite this year. But if this massive disillusion and even distrust of public monetary authorities occurs, who knows what numbers we could be looking at in 2013? But, $55 per ounce seemed about right when I made the forecast in writing and I'll stick with it.

TGR: Going to Gold Mining stocks, which you cover in your Melman Report, the big question that most investors have is when are their mining stocks going to take off and start behaving the way they expect? What do you think?

Leonard Melman: While gold has almost doubled, the major mining shares have dropped by an average of about 40%, and many of the junior shares have fallen by more. So, it's been a dismal period, especially in the last year.

The major difficulty during the past few years has been the longer timelines in advancing exploratory projects to production, due to the regulatory and environmental hurdles. When I started writing about Gold Mining and trading shares as a stockbroker in the mid-1970s, it wasn't unusual to advance a project from discovery to production within two or three years. So, you only had to raise sufficient capital to cover that period.

Now projects can take 8-15 years to get to production, if they succeed at all. That results in greater capital requirements and a lot more share dilution. That's having a negative impact in the junior sector. The major mines seem to correspond much more closely to the price of the metals themselves. But for the juniors, that long regulatory process creates a major problem for share prices and dilution.

TGR: What do you think of the rare earth market?

Leonard Melman: The rare earths have been hot numbers and then cooled off. When China first announced that it was going to reduce exports to the West, rare earth shares in North America went crazy on the upside and have come back almost as rapidly. So, it's a different situation with them. They're more a hot play of the moment as opposed to gold, which is much longer term.

Rare earths blow hot, then cold. But, then they could very easily blow hot again. The fundamental argument for rare earths is excellent. They are absolutely essential for modern technology, including defense weaponry systems. The fundamental demand for them has nowhere to go but up and questions have been raised about Chinese supply, among others. So, I think the North American rare earth junior mining shares could easily get hot again.

TGR: Where do you think things are headed from here and what should our readers be focusing on to avoid the pitfalls and make some profits when this market turns around?

Leonard Melman: I like the juniors with production financing that are actively building facilities to go into production or that have already achieved production. That enables them to grow so much faster without serious dilution.

I still love gold and silver. Silver has the added bonus of being an industrial as well as an investment metal. My big picture tells me that the great force behind gold and silver in the coming months and years is the growing fear factor. Once the public perceives that international financial matters are really getting out of control, they will start moving assets from conventional investments into the precious metals.

There was an article in Barron's in December 2010 where the author stated that, according to his research, when inflation begins to accelerate toward hyperinflation, the precious metals tend to rise 2,000% to 50,000% faster than the rate of deterioration of currency. That's an enormous factor down the road and I think, historically, it makes some sense. So, my big picture is that disillusionment with international financial monetary authorities is growing and fear will be rising. Once the image of the US Dollar as a pillar of strength begins to diminish, which I expect in the second half of this year, I think we will see real fireworks in the precious metals.

TGR: What is the best investing advice you've ever received, that you've either taken or wished you had taken? And, what's the best advice that you have for people who are just starting out as investors?

Leonard Melman: The best investment advice that I've received and want to pass on is to look for the one play that, considering the risk involved, has odds that are truly powerful in its favor and that will provide outsize rewards. And, I'll tell you exactly which one I like; the only question is the timing.

Right now, interest rates are the lowest they have ever been in history. The one interest rate future that stands out in my mind is Federal Reserve funds that are yielding virtually zero for the short term. Short-term notes are quoted at about 99.87 vs. 100.00 face value. So, they're yielding 0.13% with virtually no risk to the downside. All you're risking is 13 basis points because interest rates aren't likely to ever go below zero. The kicker is that those contracts extend more than two years out. The spring of 2014 contracts are trading now at about 99.65. So, there's 35 points potential downward action. Over the next two years, the pressure to start raising interest rates is going to become severe.

If rates reach 3%, these contracts fall to 97.00, which would provide about 265 points of potential profit. Anytime you can put logic behind an investment and have a potential reward that's 9 or 10 times the potential risk, then I'm very interested. I think the logic behind interest rates starting to rise within the next two years is quite powerful.

TGR: Great advice. Thank you so much.

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