Crash Avoidance

This money manager says crisis will be averted. But he still advises Buying Gold...

SENIOR vice president and portfolio manager with First Asset Investment Management Inc., John Stephenson has been recognized by Brendan Wood International (BWI) as one of Canada's 50 best portfolio managers for the past three years.

John Stephenson is also author of The Little Book of Commodity Investing (John Wiley & Sons, 2010), which has been translated into five languages, and is regularly quoted by Bloomberg News, Reuters, and many other leading news outlets. He writes a free bi-weekly investment newsletter, Money Focus, which reaches a global audience of more than 125,000.

Here he talks to The Gold Report about why he thinks we will avoid a worldwide economic crash but how continuing QE and government bailouts will push more investors into Buying Gold...

The Gold Report: Since you last spoke with The Gold Report in January, we've had a seemingly self-feeding cycle of expectations, plans, bailouts, lack of results and back-to-the-drawing-board. Do you see any ultimate resolution to the world's economic dilemma, or will we somehow just muddle through, or have to go through an actual crash of some sort?

John Stephenson: I think we'll basically muddle through from here. We've had several important developments over the last few weeks. The Federal Reserve's third Quantitative Easing program sees $40 billion per month targeting mainly mortgage securities. It has the potential to move the needle. There was a big rally to risk assets when that was announced but that has faded somewhat. The other huge thing is the announcement by European Central Bank (ECB) President Mario Draghi that he would defend the euro at all costs. Later he talked about a bailout plan called the Outright Monetary Transactions (OMT) program that would involve unlimited purchases of sovereign debt for up to three years. The devil is in the details and it may not get implemented in the way the market interpreted it, but nonetheless, that was very positive.

Then the Bank of Japan turned positive with its stimulation of the economy. Lastly, China announced a ¥1 trillion stimulus program directly linked to real infrastructure. So, we think that with the ECB, the Fed, and to a lesser degree the Bank of Japan and the Chinese, we have a very promising case for a slow upward grind in the market. I think the Armageddon or crash scenario has essentially been removed from the marketplace and stocks and commodities are biased higher in this environment. Is it going to be a resumption to robust growth? No, because the West, primarily Europe and to a lesser degree the US, still have slow growth ahead as consumers deleverage and as the economies get back on track.

TGR: So, basically, the world got ahead of itself in this big race to develop, and all it really did was mortgage its future. Now it's having to pay back the mortgage.

John Stephenson: I think that's absolutely right. People took out these big bets on real estate, mainly in countries like Spain, Ireland and the US. As a result, we had bubbles forming in much of the world, in sunny places where people wanted to retire like Florida, Nevada and California. The same is true in Europe, whether it be Spain, Italy, Greece, etc. So, real estate became the flavor de jour over the last decade or so and we're still dealing with the overhang and will be for some time.

Things are looking better in the US and housing prices and consumer confidence is turning up. I think the Fed has done a great job of getting the economy going. Is it perfect? No, far from it. We still have far too many people unemployed in the US Nonetheless, it's looking a lot better than it was a couple of years ago. So, that's the good news and the silver lining. In time we can work our way out of these problems. And, that's why I'm a little more optimistic than pessimistic right now.

TGR: The other big asset class is obviously stocks. Have the markets turned into little more than a big poker game with mainly short-term maneuvering and no real long-term investment strategy, or is this about all that most investors can do in this market environment?

John Stephenson: You've keyed on a couple of important things. I would say the markets certainly appear somewhat range-bound; I don't see much more upside going forward. We've had a good run with the S&P 500, up 16% year-to-date. The Toronto Stock Exchange is up roughly 4%. The Canadians have lagged and it's harder to find good value out there. Markets are trading around 12½ to 13 times next year's earnings, which is not that expensive, historically. But, the problem is the things that seem to be working, the dividend paying stocks, are getting to be quite a crowded trade.

And, I think the other thing that's happened is many people have been sitting on the sidelines waiting to get involved. You see that in mutual fund flows, where in spite of the very strong returns on the S&P 500, equity funds have had net outflows for almost all of the last 52 weeks that have been going mainly into fixed-income. Investors are scared and don't know what's going on. They see the pain, at least in their neighborhood or their community, with high levels of unemployment and lack of hiring. All the cheerleading out of Washington and even out of Wall Street just can't overcome that things are still tough. But, the reality is, at least by the numbers, that things are starting to improve. Ultimately, that's a good thing. And, it will be very good for equities going forward. I think we just need to see unemployment start falling before some enthusiasm returns in the space.

TGR: So, people just need to feel better about taking a little risk, and right now they're just parking their money and doing nothing?

John Stephenson: I think that's right. People run back to the safety of US government debt when they start worrying about the bigger problems out there, like Europe and to a lesser degree China. They would rather just get a return of capital then a return on capital. But, once rates start going up, bond funds will start losing money and maybe they'll rethink their strategy and perhaps go into equities where there seems to be some growth. At that point in the cycle, I think you'll see a reversal, which will be good for equities and potentially good for commodities as well.

TGR: So, next month you'll be speaking at the big World Money Show in Toronto. What's going to be the theme in your discussions?

John Stephenson: The talk is titled "Booms, Busts and Bailouts". I think that's what we're experiencing globally and we're going to see these rallies as news is unveiled about another round of quantitative easing – we'll probably have QE4 and QE5 before all is over. Then we'll have little busts as some of these issues disappoint. It wasn't too long ago that Spain didn't look as if it was going to approach the two European bailout funds for help. Now it looks as if they may. So, you're going to have these mini-booms and mini-busts for the next year at least and maybe well into 2014. The banking sector in Spain is one of the current issues of concern, so we'll be talking about that. We'll also be talking about the slowing in China and the potential problems looming in Japan around the corner. There's lots to talk about and I'm expecting a great turnout. We look forward to seeing as many of you there as possible.

TGR: It seems that everybody has been banking on China to carry the rest of the world. Has that been more hope and expectation than reality?

John Stephenson: China is a developing economy and some countries, like Australia, are much more linked to China because of iron ore demand and prices that have tumbled down to $88 per ton from close to $200 per ton. So, it's been a tough year for many of the bigger mining companies. China can only do so much, which Chinese officials have been saying for years. They've also been saying for years that they want slower growth and are concerned about a potential housing bubble on that gold coast. The Shanghai, Hong Kong and Beijing markets are now showing domestic inflationary worries, primarily over food, even though China's inflation is down to about 2% from around 6%. China matters now primarily as a commodities consumer. The rate of change is toward slower growth economically, which is bad for commodity prices generally. The good news is that it's trying to stimulate and there's lots of room for that. The problem is that it's going to have to do all of that in order to light a fire under commodities.

TGR: In connection with that, Australia's resources minister, Martin Ferguson, was quoted a few days ago saying that he thinks the global boom in commodity prices is over. Is he taking the Australian perspective in the iron ore market or do you think he's right overall?

John Stephenson: I don't think he's right overall. He's probably right as far as base metals and maybe iron ore are concerned. If you talk about other metals, like gold, I think he'd be much more bullish about it. Oil has a very bullish case unfolding because the days of low oil prices are dead and gone. So, I think it's really an Australian view. But, I think it's fair to say that the best days for commodities may be behind us, although it's certainly not universal. We've seen some very strong moves also in the grains over this period of time. Of course, with the exception of wheat, it's not really a market that Australia is dominant in. So, I think he's talking up his book or talking down his book, as the case may be.

TGR: On the other hand, Merrill Lynch just came out with a projection for gold to hit $2400 per ounce by 2014, based on QE3 and what may follow. That seems to be a pretty optimistic price projection from one of the big names in the investment business, if you compare that to where the Dow would go on a 35% move – 18,500. It seems as if they may be being overly optimistic. What do you think?

John Stephenson: I tend to agree with you. Could I see $2000 per ounce or even $2100 per ounce gold? Absolutely. It's fairly realistic to think that might occur in the next four to six months. The argument for gold is really that it is a currency and a hedge against the debasement of fiat or paper currency. But, in reality, that's not what's happening on the ground. The Fed is doing what it can but it's not increasing the money supply. All it is doing is buying up bonds, creating deposits at the Federal Reserve that member banks can access. The commercial banks are increasing their reserves, but until they start lending, there's really no multiplier out in the market and therefore the money supply isn't growing. Can it? Yes, but it depends on the credit health of Americans getting better, which thankfully it is. So, hopefully, we'll start seeing more lending and more spending in the economy, but right now that's not the case.

TGR: We'll have to see how realistic its projections are because Merrill Lynch is talking about all the way into 2014.

John Stephenson: That's a long way. We'll be a couple of more Money Shows down the road before we see on that one. Investors should look for higher Gold Prices but I think $2000 per ounce is probably a more realistic target, within 6 to 12 months.

TGR: Do you think it's going to take $2000 per ounce gold before people start getting really excited about the smaller explorers, or are we in an age of a hundred survivors and a whole bunch of little derelicts floating around?

John Stephenson: We could see a little culling of the herd because financing has dried up for them. Capital is a huge problem and many of these guys are reluctant to sell production forward to someone because they feel that they'd be selling away their future.

I think investors are still skeptical about the strength of the gold market. Although the actions of the Fed, the ECB and the Bank of Japan, acting in concert, are providing a good tailwind for the sector, many gold companies have had high costs and have disappointed investors for some time, so they've lost a bit of institutional following.

My suggestion to investors is to concentrate first on some of the bigger players that are also cheap relative to historical multiples. They've started to get a bit of a lift finally in the last month or so. Then, once you make a little money on those larger-cap names, you can look to the juniors that have survived and gone through some of these hiccups. Chances are those survivors are going to be around for a while longer.

TGR: So, what's your takeaway position on how investors should approach the current market?

John Stephenson: I think you'll certainly get lots of upside if Merrill Lynch and people like us at First Asset are correct, that Gold Prices will go higher. There's plenty of time to start picking away at some of these smaller names. Many of them are going to be news-flow driven. Valuations are certainly cheap. You just want to be careful to pick a few of the winners that will be survivors and are going to be able to hang through the tough times.

TGR: Thanks for checking in with us, John, and let's keep our fingers crossed until next time.

John Stephenson: I look forward to it.

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