(February, 2004)

RUSSELL SAYS “ACCUMULATE GOLD”

Chris as one of your subscribers I value your advice.  I just read Richard Russell’s report titled “Systematically Accumulate Gold.”  My question to you is should this be in the form of bullion, rare coins, stocks or a combo of all? His report gives the impression that stocks are not the place to be in the coming "Winter" of the world economy.  You may have read this article, its on Kitco site now (NOTE:  One can find Russell’s piece referred to here at www.kitco.com in the Commentaries section.)

What do you think, should we be accumulating bullion?

Thanks for your time and a great monthly newsletter.

I did read Russell's article and generally agree with it.  As I say in answer to another subscriber's question following, I feel we'll see a “70's lite” kind of stagflationary economy for the next year or better, after which the powers that be won't be able to string things out any longer, and the great unraveling will begin in more earnest.

How gold reacts remains to be seen.  I have long been skeptical of the notion that gold—or most other commodities, for that matter—would be good places to be in the kind of “Kondratieff Winter” Russell talks about.  Generally, of course, when economic activity slows noticeable, most go DOWN in value, not up.  Many think that this time around would be different, as a deflation might hurt the overextended U.S. more than other nations, and that a commensurate decline in the dollar would boost gold in dollar terms even if the economy is sliding.  Time will tell.

Apart from that—and more to the point of your question—my philosophy is that folks have a modest amount of money in physical gold as a form of “mad money.”  This, as I commented in my latest special report on the gold market, is one of the MANY items you could use as money in the event of a breakdown. 

Beyond this, I have advocated gold mining stocks as the best means for the average investor to profit from a rise in gold.  We have moved a few times from a core position (currently up to 15% of a portfolio) to larger weightings when it looked as though the sector was at its strongest, and then taking profits when it appeared overbought (as we did back around December 1.)

I'll continue to advocate this, but with two caveats.  First—though one of these days we'll load up anew once it looks like the current correction/consolidation is over—don’t forget that there are other commodity-linked stocks out there, too.  And, as I also said in my latest gold report, there are some commodities such as copper and natural gas which have even superior fundamentals to gold.

Second, as we move into the Kondratieff Winter down the road, keep in mind that there's a good chance that gold mining shares on average may NOT outperform gold, as business conditions generally become rough.  We aren't likely to have to worry about that for a while, though.

QUESTIONING THE STAGFLATION ARGUMENT

 

Chris, I don't believe in the stagflation argument.  Here's why:

The artificial stimulus caused by huge tax cuts and cash-out refinancings will soon wear off.  This will cause the economy to gradually erode.  This has already begun at retail.

Our debt and consumption-based economy cannot grow any further without job creation.  Jobs will not be created as retail demand softens and that impact ripples through the economy.

As consumers soften and jobs continue to erode, we will see increasing debt defaults by consumers and businesses.

A debt spiral will ensue where consumption declines, bankruptcies rise, and fear begins to creep back into the financial markets.  We are already seeing this with Treasury yields moving towards new lows, particularly the longer term Treasury bonds.

As rampant speculation begins to move out of commodities and financial assets, prices will rapidly decline.

The next move by the Fed will be to reduce interest rates.  This will have little effect on the economy and show how desperate the Fed is to maintain our economic bubble.

Unemployment will rise to 10%+ within 24 months from now.

Those are my predictions.  The consensus opinion that growth is picking up and that inflation pressure will build just won't happen.  That's what the Fed wants to happen, but it won't.

You make some excellent points which I generally agree with.  One of these days, we will indeed see what you seem to be predicting here; trends which have thus far been either postponed or glossed over by the Fed's continued massive injections of liquidity into the system.  The question remains “when.”

I presently expect that we'll FIRST see a period where we have a “70's lite” type of environment.  With the prospect of the corporate earnings rebound of the last few quarters peaking now—in part, due to most companies' inabilities to pass on their higher costs to consumers—earnings growth will slow markedly by the end of this year.  That will impact stock prices, as well as the willingness of most companies to boost hiring significantly.

The liquidity still present in the system will keep things muddling along.  The Fed's present efforts to drag the rest of the world into keeping monetary policy easy (or making it more so) cannot be ignored right now.  In my view, we're watching a major shift in pricing dynamics or, at least, a heck of a try to change them.  For several years, intensifying global competition and all the rest led to a regimen where China (primarily) was said to have been “exporting deflation.”  That kept consumer prices down almost across the board.  Companies responded by lopping off workers to keep the damage to their earnings from being worse than they would have been otherwise.

Having kept their game going by squeezing prices and workers, the powers that be—led by the Fed—now need to find a way for everyone (especially U.S. consumers) to service their debts, let alone take on more.  Recently, the Fed (and Treasury, as it plays its part) have had some success in getting other central banks to join in; Canada has lowered interest rates, Japan has eased policy, the U.K. and Australia have been prevented from enacting further rate hikes, and the European Central Bank is under mounting pressure to also cut interest rates.

My belief that we'll have a period of 1970's-style stagflation (though without the extremes of that time) is predicated on the expectation that the Fed will have success for a while in leading the world in what will be a round-robin type of competitive currency devaluations.  Thus, we're now seeing a Fed-led regimen of EXPORTING INFLATION to counter and, they hope, eventually supplant China's years-long one of exporting deflation. 

Consider the following snippet from Martin Barnes of the Bank Credit Analyst, in a recent missive:

“As far as monetary policy is concerned, the Fed has already made it clear that it is prepared to go to extreme lengths in order to prevent the economy from slipping into deflation.  If the Fed wants to create inflation, then it can do so by drowning the financial system in excess dollars.  Of course, the dollar would collapse, but that would be part of the reflationary process.  An end to the Super cycle would be deflationary, so one way to delay the end would be to create inflation in order to devalue the burden of outstanding debt.  The bottom line is that the demise of the Super cycle is not imminent.  The economy will suffer another downturn in the next few years, but the authorities should still be able to find ways to prevent a terminal shakeout.”

I tend to agree with this; partly because I also believe that for now, reluctant though they may be in some respects, the world's other major central banks will keep going along.  The result will be the kind of “70's lite” environment I see in the near term.  It will be following a period of that, though, that YOUR scenario will assert itself, unless one or more external shocks or other surprises speed things up.  The only question will be the timing.

GOLD ALLOCATION, PRO FUNDS AND “CANADIAN TIPS”

Have you ever addressed the quantity of precious metals one should own?

Is there a reason why you like the Pro-funds Rising Opportunities Fund versus the equivalent (?) Rydex Juno fund?

Do you have an opinion on Canadian Return Bonds?  They are like our TIPS (Treasury Inflation Protected Securities) but supposedly better as they are denominated in Canadian dollars.  Is the Canadian govt. more honest about inflation than their U.S. counterpart?

My current posture is that 15% of one's portfolio should be in the precious metals area, chiefly via gold-related equities.  A small portion of this total can and should be in “physical” gold.

As for your Pro Funds question, I like (and recently recommended) their Rising Rates Opportunity Fund due to my strengthening belief that we've seen about the lowest long-term interest rates on Treasuries we're going to.  My choice of this as opposed to the Rydex Fund is due to my liking the much broader menu of choices that Pro Funds offers (for possible future consideration.)  For those already in the Rydex group and who like them, though, the Juno Fund is also good as a play on rising interest rates into the future.

I'll take a look when I get a chance at Canada's version of TIPS.  As to whether or not Canada is more honest about inflation I don't know, but I'll try to get a couple opinions about that. 

FOREIGN MARKETS, GOLD QUESTIONS

Chris, I'm a new subscriber to National Investor from Asia. I have been wholly impressed with your suggestion to time the gold market and have realized its importance.

Given your busy schedules, I'm not sure if you would entertain individual questions. I have a few questions regarding the newsletter and in general that I should be grateful if you could take a few moments to respond.

In your newsletter you do not mention allocation of assets to other markets such as China, India, Thailand, Eastern Europe. Are these markets to be avoided as well given the imminent overall bear market condition and that you recommend sticking with individual stock?

Given the relatively small movement of the gold price similar to other foreign currencies, should gold be classified as “foreign currencies” in your recommendation of asset allocation?

I still have about 20% holding in gold shares and some futures contracts in gold. Do you expect that the signal to hold more gold shares to come any time soon?

For starters, I certainly do entertain specific questions from readers—so never hesitate to ask!  I may not answer immediately, but I eventually do make the time to answer each and every one.

I have indeed not recommended any direct investment in those countries/regions you cite, though have been an advocate in general terms of “dollar contrary” areas given the U.S. dollar's bear market.  Those have chiefly been in international bond funds.  In addition, I am bullish on most commodities given the rapidly growing appetite for many, especially in China.  So in a roundabout way, my advocating of commodity-linked stocks (preferable generally to mutual funds, though for many people the latter is the most practical means) is my “vote” on the longer-term bullish prospects for many developing areas.

I feel we'll one day see an environment eventually where the inevitable decline in America's economy and consumption is finally shrugged off by growing areas with the kind of dynamism that allows them to NOT catch a debilitating cold once the U.S. starts sneezing.  BEFORE we get to that point, though, I see pretty much all equity markets as vulnerable, since early on—once this cyclical bull move we’re in peters out—they’ll all suffer.  So, though I won't rule out someday being a stronger advocate of a more direct bet on some overseas markets, I don't believe the timing is right, and would rather be safe than sorry.

On your second point, no, I at least don't classify gold as a foreign currency.  As I discussed in my January issue, though gold has indeed been a lot less exciting in the past year or so when measured in many currencies other than the U.S. dollar, it nevertheless remains in a longer-term bullish move in all of them.  It's one, in fact, I think will soon become more pronounced in other currencies, as most other central banks join the Federal Reserve in its dragging them all into competitive devaluations of all their currencies.  The bias will remain downward most against the dollar, but it will become more apparent that commodities will also be rising more noticeably in other currencies as well.

As to your last question, and as I said in this past week's interim update, it's still too early to call the final bottom of the gold sector's recent correction.  Once we get through both the G-7 meeting and Alan Greenspan's congressional testimony, things should be a lot clearer, however; and when they are, I'll be letting everyone know what to do differently than we are now.  (NOTE:  I obviously answered this reader before my comments during the first week of February and after the G-7 came down more on the side that the gold sector’s correction has now seen its worst days.)

SATELLITE RADIO BUBBLE

            I have a broker who’s been after me to buy shares in XM Satellite Radio (NASD-XMSR) for a while.  I’ve been worried that it’s just the latest over-priced “fad” stock, but have to admit that it’s tough to sit by and watch this stock do as well as it has.  Do you have an opinion on it, or its competitor Sirius (NASD-SIRI)?

            I share your opinion, in spite of the fact that shares of both of these fad stocks have been doing handsprings for nearly a year now, with XMSR moving from around $5 per share to near $30 (it’s around $24 right now.)  Sirius has moved from well under a buck to near $4, and currently sits a smidgen under $3.

            On January 23, Sam Whitmore authored one of his media columns for Forbes.com where he closed by saying this:  “There’s just not enough space in this column to address all that ails XM and Sirius. Both are deep in the red. XM's satellites are suffering from what the firm’s 10-Q calls ‘progressive degradation’ of their solar power circuitry. XM has insurance, but the insurance company doesn't want to pay. Undaunted, XM says it will launch a ‘spare’ satellite later this year and another in 2007. XM subscriber fees of $9.95 a month will pay for this?  Meanwhile, Sirius's 10-Q says the company needs two million subscribers to reach cash flow break-even by the second quarter of 2005. And Sirius charges $12.95 a month, 25 percent more than XM.

“There are great places for satellite radio. Trucks. Yachts. Vacation cabins. A buy-and-hold portfolio isn't one of them.”

Prior to that, Whitmore had been discussing how the improving quality of local radio signals is even now undermining the attractiveness of satellite.  Local radio stations around the country are going digital, leading to much better signals and sound quality rivaling that received from satellite stations via the expensive new receivers in some cars.  As Catherine Yang reported in the January 12 issue of Business Week, Panasonic and Kenwood are coming out with the first car radios that can receive digital signals; ones which are expected in little more than a year to be price-competitive when compared to satellite receivers.  The key difference, though, is that folks will be able to listen to quality sound on their digital radios without having to pay the monthly fees tied to XM or Sirius subscriptions.

Though memberships for both Sirius and XM may still grow somewhat, the picture is one suggesting that there simply is not the vacuum for these servers to fill as some initially thought.  The 13,000 some-odd local AM and FM stations around the country—some of them owned by major media conglomerates—are not simply going to sit back and allow satellite radio to take over. 

When you look at the exorbitant amount of cash both XM and SIRI are going through, how expensive it is for them to simply obtain new members (one report I read recently suggested that it will take XMSR more than a decade to just break even on each new subscriber) and all the rest, the future is not all that bright.  And that’s especially true at current share valuations, which you rightly perceive as being akin to those of fuel cell stocks in 1998 or Internet stocks in 1999.

INSIDER SELLING—SO WHAT?

 

            Chris—first, my compliments that someone who has a bearish bias like you can still make a lot of money for his subscribers.  Thank you!

            Having said that, though (and while I’m glad that your picks continue to beat all the market averages) you seem to have missed the boat on the rebound in stocks generally.  The Nasdaq has nearly doubled from its lows.  Granted, I agree this won’t last forever.  But still we missed some nice trades that we could have added to the ones we did enter into.

            My one main question after that is:  you have talked a lot about the level of insider selling of stocks, and how that’s always been bearish for the market.  Not that I disagree with you in theory (I don’t) but all this insider selling has been shrugged off like water off a duck’s back.  Why is this so?  And, does this indicator still mean anything at all? Is it automatically a bearish vote when a corporate insider sells stock?

            Let me answer your last question first—no.  Especially with the market rebounding during 2003, a lot of insiders saw the value of both their stock and stock options in the black for the first time in three years or so.  That they decided to take advantage of the opportunity and lighten up on their own holdings for most probably made sense from both an estate planning and asset allocations standpoint, and does not reflect badly on their company’s prospects.

            In no way, however, does this completely explain an insider sell/buy ratio that went off the charts last year.  According to year-end figures from Thomson Financial, insiders in 2003 sold $26 worth of stock for every $1 they bought, the most extreme level since the service began to track insider activity back in 1990.  Three out of four times in the past that the ratio has exceeded 20 to 1, stocks have shortly thereafter turned down.

            The easy answer is that the last several months has merely been one of those four times when such heavy insider selling doesn’t tell us anything.  I tend to think that the insiders have been fundamentally right, to the extent their sales have been determined by their view that their company’s shares are too expensive.  Thwarting this indicator so far, though, has been the sheer volume of money and renewed carefree attitude of many investors.  Far from worrying about irrational exuberance, the Fed’s policies are actually “underwriting exuberance” and increasing moral hazard, as PIMCO’s Paul McCulley puts it.  I guess the problem with some of these insiders (and Yours Truly) is that they think that, at some point at least, share prices are supposed to reflect fundamental value and business prospects, rather than just be a reflection of how much money the Fed is throwing around.

            So, yes—in the end, I do believe it means something when insiders sell their shares for reasons other than their own personal financial planning.  When the current mini-mania ends, as it finally did in early 2000, others will discover that insiders’ votes on their own companies’ share prices still means something, too.

TASER, COAL STOCKS, SILVER STANDARD

Hi Chris. . .Don't know if I ever thanked you for the Taser recommendation, so if not, thanks!  Made some nice money on that one. 

What are your thoughts on coal stocks as a hedge against rising oil prices?  Also in the metals, a stock named Silver Standard?

I’m glad you had some success with Taser (NASD-TASR), though I have to admit that one of my big regrets of 2003 was getting most people stopped out of it at MUCH lower prices than the incredible $130+ per share it has since reached.  Although everyone made a pile of money on this, it's been excruciating to watch it go higher!  As the old saying goes, nobody ever went broke taking a profit, but it sure would have been nice to have let profits in TASR run farther!  I guess about the only good thing I can say about it is that—whereas everyone and his brother in the recent past has been hot on the stun gun manufacturer—Yours Truly was one of the only ones who was table-pounding bullish on the company when it was near its late 2002-early 2003 lows.

As for coal stocks, I've been keeping my eye on them, especially since most have weakened considerably of late after a strong run.  Many analysts believe as you suggest that they'll be more attractive the longer that oil and natural gas prices stay high.  In the coming days I'll be looking even more closely at them, in the hopes of even lower prices following this current correction.

Silver Standard (NASD-SSRI), as have other primarily silver-related stocks, has had a great run recently as silver prices have finally broken out of their relative lethargy.  For most of the run in precious metals over the last couple years, silver was lagging gold; recently, that's not been the case.

I still have trouble coming up with a strongly bullish case for silver.  Most of the new silver that comes to market is as a result of mining for other metals such as nickel, copper, lead, etc.  As more silver comes out—and is expected to with the heightened activity in these others—I’m having a hard time understanding where sufficient demand is coming from to ratify higher prices for the junior precious metal.  Further, if the U.S. dollar rallies further, I think silver will be vulnerable to more profit-taking; so for now I wouldn't want to be in SSRI and similar stocks that have had such strong runs but are vulnerable short-term.

I may at some time—and if further study gets me “over” my ambivalence on silver—look harder at stocks like SSRI.  I also have followed—and like—Hecla Mining (NYSE-HL), whose finances have dramatically improved over the last couple years and which, to me, represents a more solid play.


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