Inflation & Gold

"When inflation erupts everywhere, gold will take off on its own..."

INVESTORS SHOULD EXPECT short-term hesitancy in the upward movement of the Gold Price, says Frank Holmes – CEO and chief investment officer at US Global Investors, and co-author of the new Goldwatcher: Demystifying Gold Investing (John Wiley & Sons).

In this exclusive interview with The Gold Report, Holmes predicts gold will rise over the next two years thanks to the growing money supply, expanded by a change in government policies that will also help lift some junior Gold Mining stocks out of their misery.

The Gold Report: Can you start off by telling us what's going on?

Frank Holmes: Based solely on global economic indicators, commodities should be in a cyclical bear market with no bottom in sight. But there's intense pressure on policymakers to fill the deflationary vacuum that's been created by both Main Street and Wall Street. Main Street's plummeting housing prices stretched the limits of the financial system, but lawmakers in an election year will find it easier to blame Wall Street than Main Street.

TGR: Both sides are at fault...?

Frank Holmes: The abuse of leveraging is the biggest culprit. Mike Milken spoke at a conference I attended last week in Hong Kong. He said that at the height of his career he was leveraged 4-to-1. Goldman Sachs now is leveraged 20 times, so a 5% mistake would wipe them out. The combined impact of Sarbanes-Oxley, FAS 157 [mark-to-market regulations] and leverage abuse has cost New York its position as the world's financial capital. No one expected this escalation of write-downs.

When Warren Buffett bought General Re Insurance in 2002 he warned about notional valuations because he tried to sell some of the derivatives, and lost billions of dollars. He called derivatives "weapons of mass financial destruction." Everyone ignored him, and the derivative market increased 500% in five years.

TGR: Wow!

Frank Holmes: If you make a 2% mistake in the $500 trillion derivative market, that's $10 trillion. What's $10 trillion? Well, the world's total GDP is $50 trillion, and the total amount of US dollars in circulation is roughly $15 trillion. That 2% mistake wipes out 20% of the world's GDP.

We're actually experiencing huge deflation – both in housing and on Wall Street. But the Paulson package is a stopgap measure that could lead to inflation. This meltdown is just like 1974 or the Depression of the 1930s, not the 1987 quick crash. It continues to destroy confidence. Another thing that propelled this meltdown to more disastrous proportions was the rule that removed the uptick rule for short-selling.

TGR: What will fix this situation?

Frank Holmes: That's a good question. Adding untested regulations is dangerous, and the law of unexpected consequences is often negative. The combination of Sarbanes-Oxley, FAS 157 and the no uptick rule for shorting basically became toxic and led to the destruction of Lehman Brothers and Bear Stearns. Also, ideas like printing more money and the debasement of currency do not solve the credit crisis and are not good long-term solutions.

The Dollar's not going to collapse, due to loss of Asian support. All countries will support the Dollar. The reason is that they can't afford for it to fall too far because then suddenly the US would be exporting products and not importing. All the currencies will slowly debase themselves against Gold and keep the Dollar as the currency for global trade.

It appears we are now going through that inflection point moving from deflationary forces to an inflationary cycle. We had a little bit of run-up in inflation when oil ran to $150 a barrel, which was very excessive. What didn't make sense was the fact that Gold didn't rise along with oil. On the historic 10-to-1 ratio, gold should have gone to $1400 to $1500. That leads to suspicions that a few people were manipulating the price of oil because gold failed at $1,000 per ounce.

On another note, it is important to remember policymakers will do everything in their power to create liquidity and, historically, liquidity is bullish for commodities. However, our research suggests it'll take several quarters before this will affect commodity prices.

TGR: Will the market stagnate until this liquidity flows through and moves the commodities up?

Frank Holmes: You'll have to be a very selective buyer for another couple of quarters. The price correction should lose downward momentum and create a "U" shaped bottom as the capital markets begin to reflect the policies being implemented.

TGR: When you say the price correction will lose its downward momentum, do you mean this wholesale sell-off of everything?

Frank Holmes: Right.

TGR: And when you say commodities, do you mean Gold?

Frank Holmes: Asian economic activity has a big influence on the purchase of gold. At the London Gold Bullion Traders Conference in Kyoto, I was amazed to find the magnitude of the shortage of gold and silver coins. In Germany, they are lining up to Buy Gold.

TGR: Do they have supplies?

Frank Holmes: No, but they do have gold in kilo bars. Everything is sold as soon as they get it.

TGR: I tried to buy some Swiss 20 Francs today and couldn't find any.

Frank Holmes: People are paying a large premium for small coins, and the purchase of safety deposit boxes is on the rise. People have been actually stuffing dollars in them, along with gold. It's not really a 1980-style mainstream panic, however. People are continuing to buy. The growth of Gold ETFs attests to that.

Now let me try to explain some of these huge price swings in commodities, equities and emerging markets. Your readers might be interested to know that banks all have this software called VAR, or "Value At Risk". It triggers an alarm indicating a need for more capital due to escalating debt defaults. You'd think that banks would go to their prime brokerage arm and rein in hedge funds trading mortgages and de-leverage them because that's where the risk is. Your business model says, "I have defaulting mortgages, so I need to be sure our hedge fund and prime brokers aren't having similar problems."

But the banks reacted by calling every hedge fund and de-leveraging all asset classes, equities, banks and commodities. Starting August 12, 2007, some of the S&P stocks moved 15% in a day. This same margin call has now taken place about four times this past year. US banks in Japan yanked loans to small-cap companies, so those guys were scrambling to replace those loans. Situations like that are happening everywhere and they illustrate the long reach of this credit crisis.

A lot of emerging marketing investors got their noses bloodied when the US brokers called for their loans to be repaid. They will not be so quick to repeat that mistake. This ripple effect is hurting businesses. That is a concern that I heard over and over.

Fortunately, the governments of emerging markets have huge surpluses and are better equipped to handle this crisis than they were in the 1990s. All of this is good for commodities, and Gold rises in step with commodities. When inflation erupts everywhere, gold will then take off on its own with a bigger move.

TGR: When will that happen exactly?

Frank Holmes: Over the next two years gold will be well over $1,000, maybe running up to $2,000. The number-one Asian analyst, Chris Wood, is advocating a 30% gold exposure to institutions. Now, this is the number-one brokerage firm in Asia and their research is excellent.

TGR: What's the name of the firm?

Frank Holmes: CLSA-Asia Pacific Markets. It recommends a portfolio allocation of 30% gold – fifteen per cent Gold Bullion and 15% unhedged gold stocks. When an analyst of Wood's stature advises putting 30% of your portfolio into gold, you have to take note. We tell our clients to put a maximum of 5% into bullion and no more than 5% toward gold equities.

TGR: Doug Casey's latest missive rounded it up to 30% too.

Frank Holmes: The significance here is that the institutional side is getting on board with gold. That's a big deal.

TGR: Because the gold market is so small compared to the market caps these institutions deal with, even a small change in percentage would make a huge difference.

Frank Holmes: All the brokers are getting their marching orders simultaneously. What happens is that non-correlated assets begin to correlate as people seek liquidity. So everyone's saying, "I have to get cash." It's important to remember that brokers were leveraged 20 times and low-income house buyers were leveraged 99 times. This creates a chain reaction and knocks down the commodities. Several of these hedge funds have blown up, and if our holdings are similar to theirs, they've hurt us.

At US Global Investors, we went into this correction with a big cash position back in June, and we never expected such a huge correction, but our models were showing that it should be 20% to 25% cash. Then we start to nibble as things get clobbered, but they continue to get clobbered.

Last week the markets hammered every stock with liquidity. Many funds have been hit by this problem. Margin calls are driving this. It has nothing to do with the demand for Gold or the supply and discoveries.

TGR: But that should work itself out fairly quickly by the end of the year.

Frank Holmes: It was estimated that by the end of the year there would be $22 billion of resource stock investment coming out of the hedge funds. They have been forced to shut down.

It's really interesting to look at the TSE Venture Index. When the asset-backed paper problems happened last summer, retail sponsorship dropped dramatically. The US went through something similar in February when suddenly the small caps and mid-caps started losing liquidity. What we noticed was that the auction rate paper is exactly ten times the size of Canada's asset build paper crisis – $330 billion versus $33 billion. It was just before tax season, so a lot of American investors had to scramble for cash by redeeming their equity funds to pay their taxes.

TGR: Do you follow Richard Russell's Dow Theory Letters?

Frank Holmes: You mean regarding the relationship between the Transports and the Dow Industrials?

TGR: Yesterday both were down, so Dow Theory now confirms that we are in a bear market. What happens to Gold Mining stocks in a broad bear market?

Frank Holmes: Whether you have big deflation or big inflation driving the bear market, Gold Bullion does well. If it's just a normal cyclical inventory recession or whenever interest rates are above Consumer Price inflation, gold doesn't do well. Today, the Fed's funds are below the CPI rate and the printing presses are busy. I think we're at the tipping point moving from deflation to inflation.

We saw gold run to $1,000 twice because of deflation, not inflation. Massive liquidations are deflationary. Collapsing housing prices are deflationary. The price of oil running up was inflationary but it was triggered by the dollar deflation and gold moved with it. In the '30s, when you had a big deflationary cycle, gold was the best asset class. In the '70s, when you had a big inflationary cycle, gold was the best asset class.  In the '90s when there was no big inflation or deflation, gold just meandered along.

TGR: So when do you think we will reach that tipping point from deflation to inflation?

Frank Holmes: The US money supply has basically been flat for the past three months. The correlation of commodity price action and emerging market money supply has an R-squared value over 80 – that's highly correlated. We track the G-7 countries versus the E-7 (the seven most populated emerging countries in the world with available data) and track their money supply. The global money supply has not been growing rapidly. We need to get the money supply up and this will happen with the $700 billion bailout. So, we're going through a transition over the next couple of months.

TGR: When will gold respond?

Frank Holmes: There's been a six-week lag with the money supply, the same with Nasdaq index of tech stocks. If the money supply spikes, there's a 70% probability that within six weeks the Naqdaq will start to rise.

TGR: Why would an increase in the money supply impact Nasdaq?

Frank Holmes: People have more cash to spend, and some of that moves into the tech stocks. But the money supply has one of the highest correlations to Gold Bullion as a whole. When you look at stocks individually, the number-one driver is the production per share growth. After that, it's cash flow, and then reserves. You can eliminate 80% to 90% of all the noise by calculating production and the cash flow.

TGR: What criteria do you use to evaluate juniors?

Frank Holmes: Unless they have two grams of gold per ton, or a million ounces in total, junior explorers have been drifting lower and lower. Historically, in situ reserves have traded at one-tenth of an ounce of gold. So, if gold is $600, then your reserves are worth $60 per ounce. When gold was $300, they were worth $30. That was the model for determining a fair market cap for junior explorers.

With gold at $850, these companies should be worth $85 per ounce of reserves, but they're not. This amazes us. And when one of these companies is bought out, it's usually paid more than the ten times ratio. But valuations are now drifting down to $40 and $35 per ounce. So the market is basically valuing a company that has 8 million ounces as if it had only 4 million ounces.

TGR: This is a short-term phenomenon, right?

Frank Holmes: Yes, but the seniors are going to buy only those juniors that have two grams of gold per ton or a million ounces. The other juniors will just work their way out of the system or go bankrupt.

TGR: What other criteria do you use to evaluate juniors?

Frank Holmes: We ask some simple questions: Is the CEO technically competent? That means, is he a geologist? If not, that may be okay, but does he have a broad network to make up for that lack of technical knowledge? Does he know the newsletter writers, like Doug Casey, for instance? Does he know the investment bankers?

We've found that if the CEO does not know the Street, and doesn't know the newsletter writers, it doesn't matter if he's a geologist or an engineer. There's going to be no liquidity in the company's stock, unless there is a multimillion-ounce discovery with a grade of greater than 2 grams per ton. But if you have a company whose CEO knows lots of newsletter writers, gets lots of coverage, knows the value in the Street and gets research for it, that company is going to have a higher price-to-book valuation, which makes it a much more attractive investment.

TGR: Anything else you look for?

Frank Holmes: Financing is crucial. Companies that are rapidly spending money are going to run out of cash in about six months. The market undervalues them until they have financing in place.