Gold Stocks and Deflation

The impact of deflation on Gold Mining stocks...

JAY TAYLOR – editor of Jay Taylor's Gold, Energy & Tech Stocks – says the biggest challenge facing the US is deflation. In this interview with The Gold Report, he explains why market sentiment hasn't shaken his faith in Gold Mining stocks. 

The Gold Report: In the Nov. 4 edition of Hotline, you note that America's ratio of debt to gross domestic product (GDP) is north of 350%. Our total debt as a society is somewhere around $57 trillion (T). That's worse than Greece. Is deflation America's biggest economic threat?

Jay Taylor: I believe it is, however, most of my goldbug friends wouldn't agree. It is important to realize that the US is not a third-world country. It still has the world's reserve currency. The central bank, the Federal Reserve, doesn't put money into the hands of the masses. It puts money in banks. 

It's all about credit extension. That is very difficult to do now. With the debt-to-GDP ratio as it is, it's unsustainable. The markets are telling us that — not only in the US, but clearly in Europe as well. We are undergoing one of the largest debt-deleveraging periods in a long time, which may be much larger than what we went through in the 1930s.

TGR: You believe there should be no more bailouts, let this debt wrench itself out of the system and let bankruptcies occur. 

Jay Taylor: Absolutely. Most people don't understand the reason we're in trouble is because the good times that we had were false. They weren't based on savings and investment. They were based on money creation through credit extension. The nice homes, the big office buildings, fancy cars, everything — it wasn't earned, it was based on debt. Now that the debt cannot be repaid, the expansion goes into a contraction. That process has a long way to go. 

TGR: Bob Prechter of the financial forecasting firm Elliott Wave International is predicting that gold and silver "should decline in conjunction with the stock market selloff. Gold should work down toward $1,300 an ounce (oz), while silver should fall into the low $20/oz area." What's your position?

Jay Taylor: If you believe that we're in a deflationary environment, the nominal price of gold could go down and the purchasing power of it could go up a lot. The real price of gold is most important for Gold Mining companies. Before the Lehman Brothers failure in July 2008, an ounce of gold would have bought only 17% of the Rogers Raw Materials Fund. It rose to 44% by March 2009, but came back a bit to 30%. It was recently up to a new high of 47.5%. 

Gold's purchasing power is rising much more dramatically than its nominal price. Gold has fallen off its highs and is around $1,700/oz. An ounce of gold is an ounce of gold. A barrel of oil is a barrel of oil. What is a Dollar? It's a meaningless measure because Federal Reserve Chairman Ben Bernanke can create trillions of Dollars out of thin air. 

TGR: Silver's purchasing power on the Rogers Raw Materials Fund hasn't experienced quite the same gain. In June 2008 it was just below 1%. Now it's just below 3%. 

Jay Taylor: Silver has done very well, but it's much more volatile. It has outperformed gold in general since Lehman Brothers' collapse, however. 

TGR: The International Monetary Fund (IMF) has reportedly agreed to throw the Eurozone countries a lifeline of about $0.5T. Will that be enough? 

Jay Taylor: My view on Europe is the same as on the US — the kindest, gentlest thing to do would be to allow the debt to implode immediately. We're allowing sick entities to survive and eat up resources. It's contrary to free market capitalism. Large corporate interests are being protected because of their cozy relationships with government. 

A half trillion is not going to be enough. Where does the IMF get its money? Is the US going to be asked to pony up more money for Europe? Probably. Are they going to sell the rest of the gold they have? Perhaps. That's what the Soviet Union did before it collapsed.

TGR: You're biased toward credit market deflation, but you continue to be partial toward gold and Gold Mining stocks. What are the reasons for that?

Jay Taylor: Margins are widening. There is an explosion of profits for major mining companies in production before 2008. Margins have increased in this deflationary environment because the real price of gold has risen relative to the cost of mining it. 

Bob Hoy, a technical analyst in Vancouver, figures we are in the sixth large credit contraction in the last 300 years. In every case, the real price of gold has risen over 15 to 20 years. The real price of gold started to rise in 2007. We could be in the early days of a super bull market for Gold Mining shares.

I believe in the sector. I can't explain why the markets have treated the sector badly this year. The majors' profits are up very sharply, yet the share prices haven't even begun to keep up. It tells me that most of the players in the equity markets don't recognize this as a gold bull market and they don't see the potential for turnaround. They don't realize, as Bob Hoy points out, that there's probably another 15 years to go. 

Gold is going to be strong for a long time because the financial sector, deleveraging and the loss of confidence in fiat money is going to keep the real price of gold and real earnings high. I told my subscribers when things started to turn that they should build some profits and keep some cash on the sidelines because the entire sector is likely to decline in price along with the general market. 

The gold sector is being hurt badly and that's an extraordinary opportunity. Why would I sell companies that I believe in even if they've lost 80%? It would be a stupid time to sell. It would be a great time to take some of that cash that I suggested investors put aside and start to buy some of these companies as they decline. I don't see any reason to jump ship now because I believe so firmly in the fundamentals of this industry. 

TGR: Do you have any parting thoughts?

Jay Taylor: It's painful sitting with stocks in this kind of a market, but that's the nature of the beast. You hold a junior mining company and all of a sudden it takes off. You just don't know when. You have to believe in the fundamentals of the story and the chance to come up with something big. A couple of times I've walked out of a stock and a day or two later the company made a great discovery — that is really painful. 

TGR: How would you respond to someone like Rick Rule who says it's not about the 80% you lost, it's about what you do with the 20% that you have left?

Jay Taylor: I suppose that's right. Rick is a very conservative investor. He really likes to buy stocks when they're cheap. He's a very disciplined trader. You want to protect that 20%. When you get a market that's on the upside, you can make that 80% back very quickly if you're in the right stocks. 

Of course, I'd never recommend that investors back up the truck and bet the farm on any one company. I have a lot of companies on my list because I believe in diversification. These little penny mining companies, the miniscule market-cap companies, can be tenbaggers in a hurry if they're successful. Whenever you invest in a deal, you can lose 100%, but you can't lose 1,000%. The upside is limitless. 

With 20/20 hindsight I should have sold everything and waited until now to buy, but I didn't know for sure how the markets were going to treat gold stocks this year. But I've been telling investors to build some cash for this kind of environment.

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