Irrational Longer Than You're Solvent
Friday, 4/10/2015 10:00
The most contrarian bets need deep pockets to reach that final windfall...
RICK RULE needs no introduction,
writes Peter Coyne, introducing the founder of Sprott US Holdings to readers of Addison Wiggin's Daily Reckoning.
We recently had occasion to ask Rick Rule about the commodity markets...notably the danger debt and derivatives tied to the US shale gale pose while crude oil lingers in the $40-60 range.
Our full conversation is published below...
Peter Coyne: Let's dive right in. Gold has been outperforming most other currencies, with the exception of the US Dollar. Last year, I believe it outperformed most stock markets, except for the US and Canada. What's going on with gold in terms of US Dollars?
Rick Rule: Well I think, as you point out, for most people in the world gold is doing its job. The extraordinary hegemony of the US Dollar relative to almost every other mean of exchange in the world has obviously meant that gold hasn't performed particularly well in US Dollar terms, and that's partially a mystery to me.
Although the US economy seems to be outperforming almost all of its global peers, that has more to do, I think, with their weakness than the strength of the US economy. We could talk about that forever.
The truth is that for most people in the world gold has done its job in the past 14 months, and the consequence of that is that gold has held its purchasing power well. Other forms of purchasing power, except the US Dollar, have declined.
In the context of gold in US Dollar terms, I'm of sort of mixed points of view being an American. On the one hand, as an American I benefit mightily from the fact that we can paint dreams on pieces of paper and ship them overseas and receive nice stuff like stereos and Mercedes back.
I wouldn't mind if for the rest of my natural life, I'm 62, that sort of circumstance prevailed. I wouldn't want to count personally, however, on enjoying what I see as that sort of financial fiction occurring for the rest of my life. And so I've chosen to hedge my bets by owning a reasonable amount of gold.
PC: It's often said that the price of gold is the reciprocal of investors' faith in paper currencies and central bank policies. I know you were just talking about Dollar strength relative to other currencies, but what does today's Dollar price of gold tell you about what investors' faith in the Dollar and the Fed's policy?
Rick Rule: I think the faith in the US Dollar remains very strong among global investors and among US taxpayers. I personally believe that's misplaced faith, but there's no direct sort of link from my mouth to God's ear. I suspect that it wouldn't take very much diminution of that faith for the gold price to do very, very well in Dollar terms. But I'm old enough and smart enough not to tell you when I think that event might occur.
I'm intrigued by the strength of the Dollar. Not so intrigued by the relative strength of the Dollar but rather intrigued by the absolute strength of the Dollar, because I see the arithmetic surrounding the Dollar as very changed.
You'll remember, because your publication noted it, the narrative that existed when gold was much more popular in 2011; I believe the gold price at that point in time nudged $1900. And the narrative went, the arithmetic narrative, at least, went like this...
The US has $14 trillion in on-balance-sheet obligations and just under $60 trillion in off-balance-sheet obligations. By the way, a footnote, at 62 I'm beginning to resemble one of those off-balance-sheet obligations. There was a sense in 2011 coming so soon after the global financial crisis that that $14 trillion Dollars in obligations was somehow not serviceable given privately generated savings in the United States.
So here we are, what, four years later and the on-balance-sheet obligations are $18 trillion, and the off-balance-sheet obligations are estimated by the Congressional Budget Office (CBO) to be in the range of $80 trillion.
Somehow the $18 trillion in on-balance-sheet obligations and the $80 trillion relative to $60 trillion in off-balance-sheet obligations are somehow more serviceable than they were four years ago. To me this is very odd arithmetic.
We were either grossly wrong then or we're grossly wrong now.
My suspicion is that we're grossly wrong now, and my suspicion is that if people become more familiar with the arithmetic of the narrative that their faith in the narrative will be less strong and that gold, at least in nominal US Dollar terms, will be stronger.
Sorry for that wordy response, but there's sort of no other way to deal with the question.
PC: I think it's a helpful response. It gets to the heart of the next question I want to ask you. There's an old John Maynard Keynes quote that "the market can remain irrational longer than you can remain solvent."
Even if readers agree with the analysis you just gave me, you can lose a lot of money being right. And so, I wonder what you think investors should do in the meantime – stick with our narrative through thick and thin and buy gold? Or are they supposed to look to other alternatives?
Rick Rule: Well, I think it is not so much an issue of markets but rather an issue of minds. And I think you've pointed to the problem correctly.
One's outlook and one's discipline changes over time. It's very odd in my own case. As I have less time left on earth I've become much more patient.
I believe in the first instance that many investors, including many of our clients and many of your readers, have time horizons that are much too constricted and also have investment theses that read like "gotta hunch, bet a bunch", meaning that people are too long ideas that have been less well researched than they should've been. They are also too impatient.
At the same time that there is that Keynesian maxim you mentioned, there is a different maxim which has been offered up in particular by George Soros, who says that he became a billionaire by finding widely-held public precepts that were wrong and betting against them.
Certainly Soros' bet against the British Pound was just such a bet. He was short the Pound for something like 30 months. Of course, that meant he had to write a check every month – a negative carry. In the course of being wrong for 30 months he cost himself a fair number of clients and a lot of cash. But then, all of a sudden, he was right to the tune of $2 billion.
If we flash forward some years after that, there was another guy who made a pretty good call, John Paulson, on the US real estate market and in particular on subprime finance. He began to think in 2006 that there was something wrong with giving 125 percent first mortgages to people with credit problems, and everybody disagreed with him.
Paulson was way, way, way short the US mortgage market, and again he had a huge negative carry. Now mercifully for Mr.Soros and Mr.Paulson, they right-sized their bets and they had both the cash and the courage to stay the trade. In Paulson's case, although he was spending five or six million Dollars a month on the margin carry for being sure, when he became right, he became right to the tune of $20 billion.
So, I think it's important for people to learn several lessons from this discussion. One is to right size your bet. In other words, have the cash and the courage to sustain your trade because it might not go right for a year or two years or three years.
The second thing is probably to engage in reasonable diversification, because I'm not one of those who believe that an event like a decline in the US Dollar will necessarily over the course of a decade as an example greatly alter the fortunes of the best public companies in the United States, public or private.
In other words, because I think that the Dollar goes, it doesn't necessarily follow that one should be out of US equities. In fact, probably you should be holding some cash in US Dollars even knowing that the purchasing power of that Dollar is going lower.
And holding some gold and holding high-quality equity portfolio gives you the ability to take more aggressive positions for the longer term simply because it's not an all-in bet.
PC: Let's turn to interest rates. Until recently, mainstream analysts at least have been banking on a rate increase. Meanwhile, the Fed is targeting two-percent inflation – but hasn't hit the mark. They've had weaker job growth than they would've liked too. Wage growth isn't there either. Global growth is slowing down to boot. And there's trillions in Dollar-denominated debt at risk in emerging markets. The list goes on.
Do you think it's possible for the Fed to raise rates this year?
Rick Rule: I have my doubts. I don't see any particular constituency for raising rates. Very recently, last October, I listened to Dr.Alan Greenspan speak in New Orleans.
From the podium, he said something like: A strong Dollar is inconsistent with a representative democracy because more people benefited from goods and services that the next generation paid for than they did from a strong Dollar.
The strong Dollar benefited savers, and a weak Dollar benefited spenders. And in a representative democracy like our own, there are always more spenders than savers. And I think there's some truth to that statement.
I think, among other things, that if you go back to the beginning of this conversation where we talked about $18 trillion in federal on-balance-sheet obligations – without taking into account federal off-balance sheet or state obligations – that there are real serious budget challenges with a higher interest rate.
The second thing is that Americans are increasingly teaching themselves to confuse the Dow and the S&P 500 with the state of the US economy. There has become a psychological marker that says that equity prices are the same as the economy.
It would be, I think, unpleasant for the political elites that preside over an extended decline in equity prices simply because of the decline in confidence that that would engender.
I don't think that there's any doubt at all that a lot of the strength in the S&P 500, despite the many fine companies that inhabit the S&P 500, that much of the strength in the S&P 500 has come from return seeking that would otherwise probably go to savings products were the interest rate at a level that didn't penalize people for saving.
PC: Are there any companies that you think are overstretched because of that?
Rick Rule: I think the interest rate-sensitive companies are probably the most overstretched in conventional terms. People are hungry for yield, and you know there are many fine yield opportunities available in our market. But the truth is that they are priced on a delta to their yield versus the US 10-year treasury.
If the US treasury were to go from whatever it is, 1.8% to 2.8% as an example, then, to the extent that companies whose dominant investment characteristic is stable dividends and to the extent that they weren't able to increase their distribution, one would think that their share price would decline in relation to the shrinkage to the delta between their distributions and the US ten-year treasury distribution, and that can be pretty ugly.
PC: Turning to the price of oil...Jim Rickards who joined recently joined us at Agora Financial as an editor has been writing about a likely range for crude oil between $50 and $60. Is there a range for the price of oil that you're expecting in the near term?
Rick Rule: If we're defining the near term as the next 18 months, I think Jim's spot on. I think if we're looking out three years, you have to move the range higher. The truth is that despite what public companies in the US might say, $50 is nowhere near sustainable in terms of all end sustaining cost calculations for oil.
But the oil and gas industry in the United States is so enormously overcapitalized as a consequence of ten very good years that they can stand to cannibalize capital for two or three years, very much like they did in the early '80s after they gorged on capital in the 1970s.
The truth is that they will be able to produce all the way down to lifting costs – the actual cost of production – and they'll be able to do that for two or three years.
Until you see some demand growth in this country or until you see supply destruction, you won't see higher oil prices in the near term. But looking longer, we are going to need $70 in the US minimally to avoid very substantial supply destruction.
PC: A theme that we have been watching closely in these pages is one we've dubbed the "Oil Bust". Having the pleasure of working closely with Jim Rickards, I've become personally interested in this topic.
The premise is that the debt that's been accumulated by oil and gas companies – especially the smaller frackers – and the derivatives created on the back of that debt, are a powder keg. That's because the debt was issued under the assumption that the price of oil would stay near $100.
Now, the narrative goes, the longer the oil price stays in the $40 to $60 range, the more problems that debt is going to cause in the sector. It could even cause the type of contagion effect in the market, which Jim Rickards witnessed firsthand during Long Term Capital Management's collapse in 1998.
I wonder if you agree with the potential for low oil prices to threaten financial stability? Could low oil prices for an extended period of time tip the financial system into crisis?
Rick Rule: I don't agree with that thesis, despite the fact that I have respect for Jim and really enjoy reading this work in the Daily Reckoning.
The debtor in this case – the oil and gas industry – is enormously overcapitalized, and there is a lot of room to savage shareholders before creditors are savaged too severely. We'll get the test of this maybe quicker than people think.
There are several important events coming up in Q3 and Q4 that will be interesting in determining whether I am correct or Mr.Rickards is correct – and I think your readers would benefit from paying attention to them.
The first will be looking at the Q1, Q2, and Q3 quarterly balance sheets and financial statements to see how companies are doing on an operating basis in a $50 oil world when they were operating on a $90 pro forma.
The second will be, and this will be particularly important, the net present value calculations done by third-party engineers that US and Canadian firms must include as part of their annual reports, the proved developed producing reserves, the lifeblood of energy companies, last year were valued on their balance sheets at the sort of then-prevailing prices in around $90.
It will be very interesting to see, first of all, what price debt assumptions, the independent engineers that generate those valuations, use for this year's price decks. Secondly, it will be interesting to see how they view the value of the proved developed-producing reserves that these companies have on their books this year. That in turn will impact the company's ability to maintain their evergreen revolving credit facilities, their interest-only facilities.
It will determine whether or not they have extra capital to use to fund growth, which I highly doubt, or whether in the best instance those revolving credit facilities will become term facilities, meaning that they begin to make principal pay-downs.
Or in the worst set of circumstances, whether companies will have to either raise equity or sell assets to bring their leverage in line with the stated value of their reserves. There are going to be a lot of companies, particularly smaller companies in the United States and Canada in the third or fourth quarter of this year that will attempt to deal with their credit facilities by selling properties which they consider to be marginal or distal to their core franchise.
The difficulty with that is that their properties, will probably have hundreds of sellers and very few buyers. Their ability to sell their worst projects to salvage their best projects, I suspect, are going to be difficult.
I also think that you're going to see companies selling themselves in their entirety or going backwards, selling their best projects and keeping their worst projects in an attempt to keep their own salaries.
The sort of wobble that we'll see in the third and fourth quarter will determine what actually happens in 2016 and 2017 with regard to the real quantum of debt owed by US and Canadian producers in credit markets.
My suspicion is that the industry was so overcapitalized as a consequence of having ten very, very good years that they'll be able to muddle through this scenario unless the interest rate goes up by 200 or 250 basis points – in which case you could have a pretty severe situation on your hands.
PC: If it's agreeable let's pivot to actionable investments. I'd like to couch my question this way: If I was an investor and I had a limited amount of money to buy a "lottery ticket", so to speak, which should I choose – junior miners or junior oil companies?
Rick Rule: I think if somebody's looking for the lottery ticket, they buy the junior mining shares because the junior miners have been in a uniquely ugly bear market for a long time. The joint junior oil companies were putting Canadian players in the penalty box only very recently, but the junior miners began to slide in 2011.
In fact that market, if you measure it by the Toronto Stock Exchange Venture, the TSXV, is off by 83% in nominal terms and perhaps 90% in real terms in three-and-a-half years.
Now while that sounds like a spectacular wasteland, the truth is a market's that off by 90% is, by one arithmetic definition, 90% more attractive than it was when it was popular.
I think that a decline of that magnitude, particularly one that is beginning to be fairly long in the tooth – a three-and-a-half or four-year decline – is much more attractive than the 40% or 45% decline that we've seen in the junior oils over nine months.
PC: Seems like a good segue to talk about the new junior miners ETF that Sprott unveiled on Tuesday. It's called Sprott Junior Gold Miners ETF (NYSE:SGDJ), correct? Can you explain this fund's investment focus and its advantage over the established Market Vectors Junior Miners ETF?
Rick Rule: We at Sprott really like ETFs for most investors. We think that most investors lack the time or the inclination to do the work necessary to do securities research themselves.
ETFs themselves have become popular because money managers, as a consequence of their fees, don't manage to generate the returns that the simple indexes do.
What we have learned in resource-based businesses is that market-cap-weighted indexes don't perform as well as qualitative indexes in resource-based industries. That's because they're capital intensive and cyclical and, importantly, because the industries involved own depleting rather than self-sustaining assets.
Factors-based investments outweigh market-cap-based investments, and that's what the Sprott ETF business has been built on. We first challenged the industry leader, the GDX, in the large mining shares because we felt that the GDX rewarded sheer size and didn't penalize companies for misallocation of capital. Nor did they penalize companies whose reserve base and revenue base was in decline, that is in other words, self-liquidating monsters.
So, we formed our own index, the Sprott gold miners' index, ticker SGDM, to take into account things like return on capital employed, cash relative to debt, and in particular, revenue growth. We wanted to reward companies that were growing rather than self-liquidating.
And now we've chosen to do the same sort of factors-based investing in the juniors. We've driven out of our index the very smallest of the companies where the ability of the company to generate returns is in some senses beyond the company's own means and more reliant as an example on commodities prices.
We've driven out, or put differently, we've enhanced holdings of companies that generate free cash and things like that. It's more of a factors based than a market-cap-based weighted index. We have found ourselves that market leaders continue to be market leaders among the juniors, and we have found from four decades of experience now that the best companies lead us out of the worst markets and outperform substantially the markets as a whole.
So, we believe in the juniors that factors-based investing will be a much better alternative for index investors than buying the index on a market-cap-weighted basis.
PC: That's very helpful. Thank you very much for speaking with me, Rick.
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